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HSBC Holdings PLC05 March 2007 CRITICAL ACCOUNTING POLICIES-------------------------------------------------------------------------------- Our consolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the United States. We believe our policies areappropriate and fairly present the financial position of HSBC FinanceCorporation. The significant accounting policies used in the preparation of our financialstatements are more fully described in Note 2, "Summary of SignificantAccounting Policies," to the accompanying consolidated financial statements.Certain critical accounting policies, which affect the reported amounts ofassets, liabilities, revenues and expenses, are complex and involve significantjudgment by our management, including the use of estimates and assumptions. Werecognize the different inherent loss characteristics in each of our loanproducts as well as the impact of operational policies such as customer accountmanagement policies and practices and risk management/collection practices. As aresult, changes in estimates, assumptions or operational policies couldsignificantly affect our financial position or our results of operations. Webase and establish our accounting estimates on historical experience and onvarious other assumptions that are believed to be reasonable under thecircumstances, the results of which form the basis for making judgments aboutthe carrying values of assets and liabilities. Actual results may differ fromthese estimates under different assumptions, customer account managementpolicies and practices, risk management/collection practices, or otherconditions as discussed below. We believe that of the significant accounting policies used in the preparationof our consolidated financial statements, the items discussed below involvecritical accounting estimates and a high degree of judgment and complexity. Ourmanagement has discussed the development and selection of these criticalaccounting policies with our external auditors and the Audit Committee of ourBoard of Directors, including the underlying estimates and assumptions, and theAudit Committee has reviewed our disclosure relating to these accountingpolicies and practices in this MD&A. CREDIT LOSS RESERVES Because we lend money to others, we are exposed to the riskthat borrowers may not repay amounts owed to us when they become contractuallydue. Consequently, we maintain credit loss reserves at a level that we consideradequate, but not excessive, to cover our estimate of probable losses ofprincipal, interest and fees, including late, overlimit and annual fees, in theexisting portfolio. Loss reserves are set at each business unit in consultationwith Corporate Finance and Credit Risk Management. Loss reserve estimates arereviewed periodically, and adjustments are reflected through the provision forcredit losses in the 40 HSBC Finance Corporation-------------------------------------------------------------------------------- period when they become known. We believe the accounting estimate relating tothe reserve for credit losses is a "critical accounting estimate" for thefollowing reasons: - The provision for credit losses totaled $6.6 billion in 2006, $4.5 billion in 2005 and $4.3 billion in 2004 and changes in the provision can materially affect net income. As a percentage of average receivables, the provision was 4.31 percent in 2006 compared to 3.76 percent in 2005 and 4.28 percent in 2004. - Estimates related to the reserve for credit losses require us to anticipate future delinquency and charge-off trends which are uncertain and require a high degree of judgment. - The reserve for credit losses is influenced by factors outside of our control such as customer payment patterns, economic conditions such as national and local trends in housing markets, interest rates, bankruptcy trends and changes in laws and regulations. Because our loss reserve estimate involves judgment and is influenced by factorsoutside of our control, it is reasonably possible such estimates could change.Our estimate of probable net credit losses is inherently uncertain because it ishighly sensitive to changes in economic conditions which influence growth,portfolio seasoning, bankruptcy trends, trends in housing markets, the abilityof customers to refinance their adjustable rate mortgages, delinquency rates andthe flow of loans through the various stages of delinquency, or buckets, therealizable value of any collateral and actual loss exposure. Changes in suchestimates could significantly impact our credit loss reserves and our provisionfor credit losses. For example, a 10% change in our projection of probable netcredit losses on receivables could have resulted in a change of approximately$656 million in our credit loss reserve for receivables at December 31, 2006.The reserve for credit losses is a critical accounting estimate for all three ofour reportable segments. Credit loss reserves are based on estimates and are intended to be adequate butnot excessive. We estimate probable losses for consumer receivables using a rollrate migration analysis which utilizes recent historical data to estimate thelikelihood that a loan will progress through the various stages of delinquency,or buckets, and ultimately charge off. This analysis considers delinquencystatus, loss experience and severity and takes into account whether loans are inbankruptcy, have been restructured or rewritten, or are subject to forbearance,an external debt management plan, hardship, modification, extension ordeferment. In addition, our loss reserves on consumer receivables are maintainedto reflect our judgment of portfolio risk factors that may not be fullyreflected in the statistical roll rate calculation. Risk factors considered inestablishing loss reserves on consumer receivables include recent growth,product mix, bankruptcy trends, geographic concentrations, loan product featuressuch as adjustable rate loans, economic conditions such as national and localtrends in housing markets and interest rates, portfolio seasoning, accountmanagement policies and practices, current levels of charge-offs anddelinquencies, changes in laws and regulations and other items which can affectconsumer payment patterns on outstanding receivables, such as natural disastersand global pandemics. While our credit loss reserves are available to absorb losses in the entireportfolio, we specifically consider the credit quality and other risk factorsfor each of our products. We recognize the different inherent losscharacteristics in each of our products as well as customer account managementpolicies and practices and risk management/ collection practices. Charge-offpolicies are also considered when establishing loss reserve requirements toensure the appropriate reserves exist for products with longer charge-offperiods. We also consider key ratios such as reserves as a percentage ofnonperforming loans, reserves as a percentage of net charge-offs and number ofmonths charge-off coverage in developing our loss reserve estimate. In additionto the above procedures for the establishment of our credit loss reserves, ourRetail Credit Risk Management department independently evaluates the adequacy ofour loss reserve levels. We periodically re-evaluate our estimate of probable losses for consumerreceivables. Changes in our estimate are recognized in our statement of incomeas provision for credit losses in the period that the estimate is changed. Ourcredit loss reserves for receivables increased $2.1 billion from December 31,2005 to $6.6 billion at December 31, 2006 as a result of higher loss estimatesin our Mortgage Services business due to the deteriorating performance in thesecond lien and portions of the first lien real estate secured loans acquired in2005 and 2006, higher levels of receivables due in part to lower securitizationlevels, higher overall delinquency 41 HSBC Finance Corporation-------------------------------------------------------------------------------- levels in our portfolio driven by growth and portfolio seasoning and the impactof the acquisition of Metris in December 2005. These increases were partiallyoffset by lower personal bankruptcy levels, a reduction in the estimated lossexposure resulting from Katrina and the benefits of stable unemployment in theUnited States. At December 31, 2006, we recorded loss reserves at our MortgageServices business of $2.1 billion that included estimates of losses attributableto ARM resets on first and second liens, a higher charge-off rate and expectedloss severity on second liens generally and particularly, second lienssubordinate to ARMs held by other lenders that face a rate reset in the nextthree years. Our reserves as a percentage of receivables were 4.07 percent atDecember 31, 2006, 3.23 percent at December 31, 2005 and 3.39 percent atDecember 31, 2004. Reserves as a percentage of receivables increased compared toDecember 31, 2005 primarily due to higher real estate loss estimates asdiscussed above. For more information about our charge-off and customer account managementpolicies and practices, see "Credit Quality - Delinquency and Charge-offs" and"Credit Quality - Customer Account Management Policies and Practices." GOODWILL AND INTANGIBLE ASSETS Goodwill and intangible assets with indefinitelives are not subject to amortization. Intangible assets with finite lives areamortized over their estimated useful lives. Goodwill and intangible assets arereviewed annually on July 1 for impairment using discounted cash flows, butimpairment is reviewed earlier if circumstances indicate that the carryingamount may not be recoverable. We consider significant and long-term changes inindustry and economic conditions to be our primary indicator of potentialimpairment. We believe the impairment testing of our goodwill and intangibles is a criticalaccounting estimate due to the level of goodwill ($7.0 billion) and intangibleassets ($2.2 billion) recorded at December 31, 2006 and the significant judgmentrequired in the use of discounted cash flow models to determine fair value.Discounted cash flow models include such variables as revenue growth rates,expense trends, interest rates and terminal values. Based on an evaluation ofkey data and market factors, management's judgment is required to select thespecific variables to be incorporated into the models. Additionally, theestimated fair value can be significantly impacted by the cost of capital usedto discount future cash flows. The cost of capital percentage is generallyderived from an appropriate capital asset pricing model, which itself depends ona number of financial and economic variables which are established on the basisof management's judgment. Because our fair value estimate involves judgment andis influenced by factors outside our control, it is reasonably possible suchestimates could change. When management's judgment is that the anticipated cashflows have decreased and/or the cost of capital has increased, the effect willbe a lower estimate of fair value. If the fair value is determined to be lowerthan the carrying value, an impairment charge will be recorded and net incomewill be negatively impacted. Impairment testing of goodwill requires that the fair value of each reportingunit be compared to its carrying amount. A reporting unit is defined as anydistinct, separately identifiable component of an operating segment for whichcomplete, discrete financial information is available that management regularlyreviews. For purposes of the annual goodwill impairment test, we assigned ourgoodwill to our reporting units. At July 1, 2006, the estimated fair value ofeach reporting unit exceeded its carrying value, resulting in none of ourgoodwill being impaired. Impairment testing of intangible assets requires that the fair value of theasset be compared to its carrying amount. For all intangible assets, at July 1,2006, the estimated fair value of each intangible asset exceeded it carryingvalue and, as such, none of our intangible assets were impaired. Included in the sale of our European Operations in November 2006, was $13million of goodwill attributable to this business. Subsequent to the sale, weperformed an interim goodwill impairment test for our business remaining in theU.K. and European operations as required by SFAS No. 142, "Goodwill and OtherIntangible Assets" ("SFAS No. 142"). As the estimated fair value of ourremaining U.K. and European operations exceeded our carrying value subsequent tothe sale, we concluded that the remaining goodwill assigned to this reportingunit was not impaired. 42 HSBC Finance Corporation-------------------------------------------------------------------------------- As a result of the adverse change in the business climate experienced by ourMortgage Services business in the second half of 2006, we performed an interimgoodwill impairment test for this reporting unit as of December 31, 2006. As theestimated fair value of our Mortgage Services business exceeded our carryingvalue, we concluded that the remaining goodwill assigned to this reporting unitwas not impaired. VALUATION OF DERIVATIVE INSTRUMENTS AND DERIVATIVE INCOME We regularly usederivative instruments as part of our risk management strategy to protect thevalue of certain assets and liabilities and future cash flows against adverseinterest rate and foreign exchange rate movements. All derivatives arerecognized on the balance sheet at fair value. As of December 31, 2006, therecorded fair values of derivative assets and liabilities were $1,461 millionand $1,222 million, respectively. We believe the valuation of derivativeinstruments is a critical accounting estimate because certain instruments arevalued using discounted cash flow modeling techniques in lieu of market valuequotes. These modeling techniques require the use of estimates regarding theamount and timing of future cash flows, which are also susceptible tosignificant change in future periods based on changes in market rates. Theassumptions used in the cash flow projection models are based on forward yieldcurves which are also susceptible to changes as market conditions change. We utilize HSBC Bank USA to determine the fair value of substantially all of ourderivatives using these modeling techniques. We regularly review the results ofthese valuations for reasonableness by comparing to an internal determination offair value or third party quotes. Significant changes in the fair value canresult in equity and earnings volatility as follows: - Changes in the fair value of a derivative that has been designated and qualifies as a fair value hedge, along with the changes in the fair value of the hedged asset or liability (including losses or gains on firm commitments), are recorded in current period earnings. - Changes in the fair value of a derivative that has been designated and qualifies as a cash flow hedge are recorded in other comprehensive income to the extent of its effectiveness, until earnings are impacted by the variability of cash flows from the hedged item. - Changes in the fair value of a derivative that has not been designated as an effective hedge is reported in current period earnings. A derivative designated as an effective hedge will be tested for effectivenessin virtually all circumstances under the long-haul method (which at December 31,2006 comprises 100 percent of our hedge portfolio based on notional amountseligible for hedge accounting). For these transactions, we formally assess, bothat the inception of the hedge and on a quarterly basis, whether the derivativeused in a hedging transaction has been and is expected to continue to be highlyeffective in offsetting changes in fair values or cash flows of the hedged item.This assessment is conducted using statistical regression analysis. If it is determined as a result of this assessment that a derivative is notexpected to be a highly effective hedge or that it has ceased to be a highlyeffective hedge, we discontinue hedge accounting as of the beginning of thequarter in which such determination was made. We also believe the assessment ofthe effectiveness of the derivatives used in hedging transactions is a criticalaccounting estimate due to the use of statistical regression analysis in makingthis determination. Similar to discounted cash flow modeling techniques,statistical regression analysis also requires the use of estimates regarding theamount and timing of future cash flows, which are susceptible to significantchange in future periods based on changes in market rates. Statisticalregression analysis also involves the use of additional assumptions includingthe determination of the period over which the analysis should occur as well asselecting a convention for the treatment of credit spreads in the analysis. Thestatistical regression analysis for our derivative instruments is performed byeither HSBC Bank USA or an independent third party. The outcome of the statistical regression analysis serves as the foundation fordetermining whether or not the derivative is highly effective as a hedginginstrument. This can result in earnings volatility as the mark-to-market onderivatives which do not qualify as effective hedges and the ineffectivenessassociated with qualifying hedges are recorded in current period earnings. Themark-to market on derivatives which do not qualify as effective hedges was $28million in 2006, $156 million in 2005 and $442 million in 2004. The 43 HSBC Finance Corporation-------------------------------------------------------------------------------- ineffectiveness associated with qualifying hedges was $169 million in 2006, $41million in 2005 and $1 million in 2004. See "Results of Operations" inManagement's Discussion and Analysis of Financial Condition and Results ofOperations for a discussion of the yearly trends. For more information about our policies regarding the use of derivativeinstruments, see Note 2, "Summary of Significant Accounting Policies," and Note14, "Derivative Financial Instruments," to the accompanying consolidatedfinancial statements. CONTINGENT LIABILITIES Both we and certain of our subsidiaries are parties tovarious legal proceedings resulting from ordinary business activities relatingto our current and/or former operations which affect all three of our reportablesegments. Certain of these activities are or purport to be class actions seekingdamages in significant amounts. These actions include assertions concerningviolations of laws and/or unfair treatment of consumers. Due to the uncertainties in litigation and other factors, we cannot be certainthat we will ultimately prevail in each instance. Also, as the ultimateresolution of these proceedings is influenced by factors that are outside of ourcontrol, it is reasonably possible our estimated liability under theseproceedings may change. However, based upon our current knowledge, our defensesto these actions have merit and any adverse decision should not materiallyaffect our consolidated financial condition, results of operations or cashflows. RECEIVABLES REVIEW-------------------------------------------------------------------------------- The following table summarizes receivables at December 31, 2006 and increases(decreases) over prior periods: INCREASES (DECREASES) FROM --------------------------------- DECEMBER 31, DECEMBER 31, 2005 2004 DECEMBER 31, --------------- --------------- 2006 $ % $ %------------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS) Real estate secured(1)........................ $ 97,761 $14,935 18.0% $32,941 50.8%Auto finance.................................. 12,504 1,800 16.8 4,960 65.7Credit card................................... 27,714 3,604 14.9 13,079 89.4Private label................................. 2,509 (11) (0.4) (902) (26.4)Personal non-credit card...................... 21,367 1,822 9.3 5,239 32.5Commercial and other.......................... 181 (27) (13.0) (136) (42.9) -------- ------- ----- ------- -----Total receivables............................. $162,036 $22,123 15.8% $55,181 51.6% ======== ======= ===== ======= ===== --------------- (1) Real estate secured receivables are comprised of the following: INCREASES (DECREASES) FROM ------------------------------- DECEMBER 31, DECEMBER 31, 2005 2004 DECEMBER 31, -------------- -------------- 2006 $ % $ % ------------------------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS) Mortgage Services........................................... $47,968 $ 6,413 15.4% $19,265 67.1% Consumer Lending............................................ 46,226 8,004 20.9 13,003 39.1 Foreign and all other....................................... 3,567 518 17.0 673 23.3 ------- ------- ---- ------- ---- Total real estate secured................................... $97,761 $14,935 18.0% $32,941 50.8% ======= ======= ==== ======= ==== 44 HSBC Finance Corporation-------------------------------------------------------------------------------- REAL ESTATE SECURED RECEIVABLES Real estate secured receivables can be furtheranalyzed as follows: INCREASES (DECREASES) FROM --------------------------------- DECEMBER 31, DECEMBER 31, 2005 2004 DECEMBER 31, --------------- --------------- 2006 $ % $ %------------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS) Real estate secured: Closed-end: First lien............................... $77,901 $11,082 16.6% $23,769 43.9% Second lien.............................. 15,090 3,275 27.7 7,168 90.5 Revolving: First lien............................... 556 (70) (11.2) (228) (29.1) Second lien.............................. 4,214 648 18.2 2,232 112.6 ------- ------- ----- ------- -----Total real estate secured..................... $97,761 $14,935 18.0% $32,941 50.8% ======= ======= ===== ======= ===== Real estate secured receivables increased significantly over the year-ago perioddriven by growth in our branch and correspondent businesses. Growth in ourbranch-based Consumer Lending business improved because of higher sales volumesthan in the prior year as we continue to emphasize real estate secured loans,including a near-prime mortgage product we first introduced in 2003. Alsocontributing to the increase was the acquisition of the $2.5 billion Championportfolio in November 2006, as well as the $.4 billion in 2006 and the $1.7billion in 2005 of acquisitions from a portfolio acquisition program. OurMortgage Services correspondent business experienced growth in the first sixmonths of 2006 as management continued to focus on junior lien loans throughportfolio acquisitions and expanded our sources for purchasing newly originatedloans from flow correspondents. This growth was partially offset when managementrevised its business plan and reduced purchases of second lien and selectedhigher risk products in the second half of 2006. These actions combined withnormal portfolio attrition, resulted in a decline in the overall portfoliobalance at our Mortgage Services business since June 2006. In addition, adecline in loan prepayments in 2006 due to the current rising interest rateenvironment resulted in lower run-off rates for our real estate securedportfolio. In 2005 we expanded our Canadian branch operations which has alsoexperienced strong real estate secured receivable growth. 45 HSBC Finance Corporation-------------------------------------------------------------------------------- The following table summarizes various real estate secured receivablesinformation for our Mortgage Services and Consumer Lending businesses: YEAR ENDED DECEMBER 31, --------------------------------------------------------------- 2006 2005 2004 ------------------- ------------------- ------------------- MORTGAGE CONSUMER MORTGAGE CONSUMER MORTGAGE CONSUMER SERVICES LENDING SERVICES LENDING SERVICES LENDING--------------------------------------------------------------------------------------------------- (IN MILLIONS) Fixed rate........................ $21,733 $42,675(1) $18,876 $36,415 $12,789 $31,947Adjustable rate................... 26,235 3,551 22,679 $ 1,807 15,914 1,276 ------- ------- ------- ------- ------- -------Total............................. $47,968 $46,226 $41,555 $38,222 $28,703 $33,223 ======= ======= ======= ======= ======= =======First lien........................ $38,031 $39,684 $33,897 $33,017 $25,225 $29,287Second lien....................... 9,937 6,542 7,658 5,205 3,478 3,936 ------- ------- ------- ------- ------- -------Total............................. $47,968 $46,226 $41,555 $38,222 $28,703 $33,223 ======= ======= ======= ======= ======= =======Adjustable rate................... $20,108 $ 3,551 $17,826 $ 1,807 $14,859 $ 1,276Interest only..................... 6,127 - 4,853 - 1,055 - ------- ------- ------- ------- ------- -------Total adjustable rate............. $26,235 $ 3,551 $22,679 $ 1,807 $15,914 $ 1,276 ======= ======= ======= ======= ======= =======Total stated income (low documentation).................. $11,772 $ - $ 7,344 $ - $ 3,112 $ - ======= ======= ======= ======= ======= ======= --------------- (1) Includes interest-only loans of $46 million. At December 31, 2006 real estate secured loans originated and acquiredsubsequent to December 31, 2004 by our Mortgage Services business accounted forapproximately 70 percent of total Mortgage Services receivables in a first lienand approximately 90 percent of total Mortgage Services receivables in a secondlien position. AUTO FINANCE RECEIVABLES Auto finance receivables increased over the year-agoperiod due to organic growth principally in the near-prime portfolio. Weexperienced increases in newly originated loans acquired from our dealer networkand growth in the consumer direct loan program. Additionally in 2006, weexperienced continued growth from the expansion of an auto finance programintroduced in Canada in the second quarter of 2004 which at December 31, 2006,has grown to a network of 2,000 active dealer relationships. CREDIT CARD RECEIVABLES Credit card receivables reflect strong domestic organicgrowth in our Union Privilege and non-prime portfolios including Metris. Alsocontributing to the growth was the successful launch of a MasterCard/Visa creditcard program in Canada in 2005. Lower securitization levels also contributed tothe increase at December 31, 2006. Receivable balances at December 31, 2005 wereimpacted by the $5.3 billion of receivables acquired as part of our acquisitionof Metris as well as the sale of our U.K. credit card business which included$2.2 billion of MasterCard/Visa receivables. PRIVATE LABEL RECEIVABLES Private label receivables decreased in 2006 as aresult of lower retail sales volumes in the U.K. and the termination of newdomestic retail sales contract originations in October 2006, partially offset bygrowth in our Canadian business. 46 HSBC Finance Corporation-------------------------------------------------------------------------------- PERSONAL NON-CREDIT CARD RECEIVABLES Personal non-credit card receivables arecomprised of the following: INCREASES (DECREASES) FROM ---------------------------------- DECEMBER 31, DECEMBER 31, 2005 2004 DECEMBER 31, --------------- --------------- 2006 $ % $ %----------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Domestic personal non-credit card........... $13,763 $2,369 20.8% $5,798 72.8%Union Plus personal non-credit card......... 235 (98) (29.4) (240) (50.5)Personal homeowner loans.................... 4,247 74 1.8 639 17.7Foreign personal non-credit card............ 3,122 (523) (14.3) (958) (23.5) ------- ------ ----- ------ -----Total personal non-credit card receivables............................... $21,367 $1,822 9.3% $5,239 32.5% ======= ====== ===== ====== ===== Personal non-credit card receivables increased during 2006 as a result ofincreased marketing, including several large direct mail campaigns. Domestic and foreign personal non-credit card loans (cash loans with nosecurity) are made to customers who may not qualify for either a real estatesecured or personal homeowner loan ("PHL"). The average personal non-credit cardloan is approximately $6,600 and 46 percent of the personal non-credit cardportfolio is closed-end with terms ranging from 12 to 60 months. The Union Pluspersonal non-credit card loans are part of our affinity relationship with theAFL-CIO and are underwritten similar to other personal non-credit card loans. PHL's typically have terms of 120 to 240 months and are subordinate lien, homeequity loans with high (100 percent or more) combined loan-to-value ratios whichwe underwrite, price and manage like unsecured loans. The average PHL isapproximately $14,000. Because recovery upon foreclosure is unlikely aftersatisfying senior liens and paying the expenses of foreclosure, we do notconsider the collateral as a source for repayment in our underwriting.Historically, these loans have performed better from a credit loss perspectivethan traditional unsecured loans as consumers are more likely to pay securedloans than unsecured loans in times of financial distress. DISTRIBUTION AND SALES We reach our customers through many differentdistribution channels and our growth strategies vary across product lines. TheConsumer Lending business originates real estate and personal non-credit cardproducts through its retail branch network, direct mail, telemarketing,strategic alliances and Internet applications and purchases loans as part of aportfolio acquisition program. The Mortgage Services business originates realestate secured receivables sourced through brokers and purchases real estatesecured receivables primarily through correspondents. Private label receivablesare generated through point of sale, merchant promotions, application displays,Internet applications, direct mail and telemarketing. Auto finance receivablesare generated primarily through dealer relationships from which installmentcontracts are purchased. Additional auto finance receivables are generatedthrough direct lending which includes alliance partner referrals, Internetapplications and direct mail as well as in our Consumer Lending branches. Creditcard receivables are generated primarily through direct mail, telemarketing,Internet applications, application displays including in our Consumer Lendingretail branch network, promotional activity associated with our co-branding andaffinity relationships, mass media advertisements and merchant relationshipssourced through our Retail Services business. We also supplementinternally-generated receivable growth with strategic portfolio acquisitions. Our acquisition by HSBC enabled us to enlarge our customer base throughcross-selling products to HSBC customers as well as generate new business withvarious major corporations. The rebranding of the majority of our U.S. andCanadian businesses to the HSBC brand has positively impacted these efforts. AConsumer Finance team, which was established in 2004, has worked throughout 2005and 2006 on a consultative basis to extend consumer finance offerings in selectemerging markets across the HSBC Group. Based on certain criteria, we offer personal non-credit card customers who meetour current underwriting standards the opportunity to convert their loans intoreal estate secured loans. This enables our customers to 47 HSBC Finance Corporation-------------------------------------------------------------------------------- have access to additional credit at lower interest rates. This also reduces ourpotential loss exposure and improves our portfolio performance as previouslyunsecured loans become secured. We converted approximately $665 million ofpersonal non-credit card loans into real estate secured loans in 2006 and $652million in 2005. It is not our practice to rewrite or reclassify delinquentsecured loans (real estate or auto) into personal non-credit card loans. RESULTS OF OPERATIONS-------------------------------------------------------------------------------- Unless noted otherwise, the following discusses amounts reported in our ownedbasis statement of income. NET INTEREST INCOME The following table summarizes net interest income: YEAR ENDED DECEMBER 31, 2006 (1) 2005 (1) 2004 (1)----------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Finance and other interest income......... $17,562 11.31% $13,216 10.61% $10,945 10.28%Interest expense.......................... 7,374 4.75 4,832 3.88 3,143 2.95 ------- ----- ------- ----- ------- -----Net interest income....................... $10,188 6.56% $ 8,384 6.73% $ 7,802 7.33% ======= ===== ======= ===== ======= ===== --------------- (1) % Columns: comparison to average owned interest-earning assets. The increase in net interest income during 2006 was due to higher averagereceivables and higher overall yields, partially offset by higher interestexpense. Overall yields increased due to increases in our rates on fixed andvariable rate products which reflected market movements and various otherrepricing initiatives which in 2006 included reduced levels of promotional ratebalances. Yields in 2006 were also favorably impacted by receivable mix withincreased levels of higher yielding products such as credit cards, due in partto the full year benefit from the Metris acquisition and reduced securitizationlevels; higher levels of personal non-credit card receivables due to growth andhigher levels of second lien real estate secured loans. The higher interestexpense, which contributed to lower net interest margin, was due to a largerbalance sheet and a significantly higher cost of funds due to a rising interestrate environment. In addition, as part of our overall liquidity managementstrategy, we continue to extend the maturity of our liability profile whichresults in higher interest expense. Our purchase accounting fair valueadjustments include both amortization of fair value adjustments to our externaldebt obligations and receivables. Amortization of purchase accounting fair valueadjustments increased net interest income by $418 million in 2006, whichincluded $62 million relating to Metris and $520 million in 2005, which included$4 million relating to Metris. The increase in net interest income during 2005 was due to higher averagereceivables and a higher overall yield, partially offset by higher interestexpense. Overall yields increased as our rates on variable rate productsincreased in line with market movements and other repricing initiatives morethan offset a decline in real estate secured and auto finance yields. Changes inreceivable mix also contributed to the increase in yield as the impact ofincreased levels of higher yielding credit card and personal non-credit cardreceivables due to lower securitization levels was partially offset by growth inlower yielding real estate secured receivables. Receivable mix was alsosignificantly impacted by lower levels of private label receivables as a resultof the sale of our domestic private label portfolio (excluding retail salescontracts at our consumer lending business) in December 2004. Amortization ofpurchase accounting fair value adjustments increased net interest income by $520million in 2005 and $743 million in 2004. Net interest margin was 6.56 percent in 2006, 6.73 percent in 2005 and 7.33percent in 2004. Net interest margin decreased in both 2006 and 2005 as theimprovement in the overall yield on our receivable portfolio, as 48 HSBC Finance Corporation-------------------------------------------------------------------------------- discussed above, was more than offset by the higher funding costs. The followingtable shows the impact of these items on net interest margin: 2006 2005-------------------------------------------------------------------------- Net interest margin - December 31, 2005 and 2004, respectively.............................................. 6.73% 7.33%Impact to net interest margin resulting from: Bulk sale of domestic private label portfolio in December 2004................................................... - (.24) Receivable pricing........................................ .32 .11 Receivable mix............................................ .07 .12 Sale of U.K. card business in December 2005............... .04 - Metris acquisition in December 2005....................... .34 .03 Cost of funds change...................................... (.89) (.79) Investment securities mix................................. - .06 Other..................................................... (.05) .11 ---- ----Net interest margin - December 31, 2006 and 2005, respectively.............................................. 6.56% 6.73% ==== ==== The varying maturities and repricing frequencies of both our assets andliabilities expose us to interest rate risk. When the various risks inherent inboth the asset and the debt do not meet our desired risk profile, we usederivative financial instruments to manage these risks to acceptable interestrate risk levels. See "Risk Management" for additional information regardinginterest rate risk and derivative financial instruments. PROVISION FOR CREDIT LOSSES The provision for credit losses includes currentperiod net credit losses and an amount which we believe is sufficient tomaintain reserves for losses of principal, interest and fees, including late,overlimit and annual fees, at a level that reflects known and inherent losses inthe portfolio. Growth in receivables and portfolio seasoning ultimately resultin higher provision for credit losses. The provision for credit losses may alsovary from year to year depending on a variety of additional factors includingproduct mix and the credit quality of the loans in our portfolio including,historical delinquency roll rates, customer account management policies andpractices, risk management/collection policies and practices related to our loanproducts, economic conditions such as national and local trends in housingmarkets and interest rates, changes in laws and regulations and our analysis ofperformance of products originated or acquired at various times. The following table summarizes provision for owned credit losses: YEAR ENDED DECEMBER 31, 2006 2005 2004-------------------------------------------------------------------------------------- (IN MILLIONS) Provision for credit losses................................. $6,564 $4,543 $4,334 Our provision for credit losses increased $2,021 million during 2006. Theprovision for credit losses in 2005 included increased provision expense of $185million relating to Katrina and $113 million in the fourth quarter due tobankruptcy reform legislation. Excluding these adjustments and a subsequentrelease of $90 million of Katrina reserves in 2006, the provision for creditlosses increased $2,409 million or 57 percent in 2006. The increase in theprovision for credit losses was largely driven by deterioration in theperformance of mortgage loans acquired in 2005 and 2006 by our Mortgage Servicesbusiness, particularly in the second lien and portions of the first lienportfolios which has resulted in higher delinquency, charge-off and lossestimates in these portfolios. This deterioration worsened considerably in thefourth quarter of 2006, largely related to the first lien adjustable ratemortgage portfolio as well as loans in the second lien portfolio. We have nowbeen able to determine that a significant number of our second lien customershave underlying adjustable rate first mortgages that face repricing in thenear-term which has impacted the probability of repayment on the related secondlien mortgage loan. As the interest rate adjustments will occur in anenvironment of substantially higher interest rates, lower home valueappreciation and tightening credit, we expect the probability of default 49 HSBC Finance Corporation-------------------------------------------------------------------------------- for adjustable rate first mortgages subject to repricing as well as any secondlien mortgage loans that are subordinate to an adjustable rate first lien willbe greater than what we have historically experienced. Also contributing to this increase in provision in 2006 was the impact of higherreceivable levels and normal portfolio seasoning including the Metris portfolioacquired in December 2005. These increases were partially offset by reducedbankruptcy filings, the benefit of stable unemployment levels in the UnitedStates and the sale of the U.K. card business in December 2005. Net charge-offdollars for 2006 increased $866 million compared to 2005 driven by our MortgageServices business, as loans originated and acquired in 2005 and early 2006 areexperiencing higher charge-offs. Also contributing to the increase in netcharge-off dollars was higher credit card charge-off due to the full year impactof the Metris portfolio, the one-time accelerations of charge-offs at our AutoFinance business due to a change in policy, the discontinuation of a forbearanceprogram at our U.K. business (see "Credit Quality" for further discussion) andthe impact of higher receivable levels and portfolio seasoning in our autofinance and personal non-credit card portfolios. These increases were partiallyoffset by the impact of reduced bankruptcy levels following the spike in filingsand subsequent charge-off we experienced in the fourth quarter of 2005 as aresult of the legislation enacted in October 2005, the benefit of stableunemployment levels in the United States, and the sale of the U.K. card businessin December 2005. Our provision for credit losses increased during 2005 primarily due to increasedcredit loss exposure as a result of Katrina and higher bankruptcy losses due toincreased bankruptcy filings as a result of a new bankruptcy law in the UnitedStates. Excluding the increased credit loss provision related to Katrina and theimpact from the increased bankruptcy filings in 2005, our provision for creditlosses declined in 2005 as a shift in portfolio mix to higher levels of securedreceivables, primarily as a result of the sale of our domestic private labelportfolio (excluding retail sales contracts at our Consumer Lending business) inDecember 2004, were partially offset by increased requirements due to receivablegrowth, including lower securitization levels and higher credit loss exposure inthe U.K. Net charge-off dollars decreased in 2005 compared to 2004 primarily dueto the lower delinquency levels we experienced as a result of the strongeconomy. These improvements were partially offset by receivable growth as wellas higher bankruptcy related charge-offs in the fourth quarter of 2005 as aresult of a new bankruptcy law in the United States. We increased our credit loss reserves in both 2006 and 2005 as the provision forcredit losses was $2,045 million greater than net charge-offs in 2006 (whichincluded $1,668 million related to our Mortgage Services business) and $890million greater than net charge-off in 2005. The provision as a percent ofaverage owned receivables was 4.31 percent in 2006, 3.76 percent in 2005 and4.28 percent in 2004. The increase in 2006 reflects higher loss estimates andcharge-offs at our Mortgage Services business as discussed above, as well ashigher dollars of delinquency in our other businesses driven by growth andportfolio seasoning. Reserve levels also increased due to higher early stagedelinquency consistent with the industry trend in certain Consumer Lending realestate secured loans originated since late 2005. The decrease in 2005 reflectsreceivable growth, partially offset by the impact of Katrina and higherprovision resulting from the increased bankruptcy filings as a result of newbankruptcy legislation in the United States. See "Critical Accounting Policies," "Credit Quality," "Analysis of Credit LossReserves Activity" and "Reconciliations to U.S. GAAP Financial Measures" foradditional information regarding our loss reserves and the adoption of FFIECpolicies. See Note 7, "Credit Loss Reserves" in the accompanying consolidatedfinancial statements for additional analysis of loss reserves. 50 HSBC Finance Corporation-------------------------------------------------------------------------------- OTHER REVENUES The following table summarizes other revenues: YEAR ENDED DECEMBER 31, 2006 2005 2004-------------------------------------------------------------------------------------- (IN MILLIONS) Securitization related revenue.............................. $ 167 $ 211 $1,008Insurance revenue........................................... 1,001 997 882Investment income........................................... 274 134 137Derivative income........................................... 190 249 511Fee income.................................................. 1,911 1,568 1,091Enhancement services revenue................................ 515 338 251Taxpayer financial services revenue......................... 258 277 217Gain on bulk sale of private label receivables.............. - - 663Gain on receivable sales to HSBC affiliates................. 422 413 39Servicing fees from HSBC affiliates......................... 506 440 57Other income................................................ 179 336 307 ------ ------ ------Total other revenues........................................ $5,423 $4,963 $5,163 ====== ====== ====== Securitization related revenue is the result of the securitization of ourreceivables and includes the following: YEAR ENDED DECEMBER 31, 2006 2005 2004---------------------------------------------------------------------------------- (IN MILLIONS) Net initial gains(1)........................................ $ - $ - $ 25Net replenishment gains(2).................................. 30 154 414Servicing revenue and excess spread......................... 137 57 569 ---- ---- ------Total....................................................... $167 $211 $1,008 ==== ==== ====== --------------- ()(1) Net initial gains reflect inherent recourse provisions of $47 million in 2004. ()(2) Net replenishment gains reflect inherent recourse provisions of $41 million in 2006, $252 million in 2005 and $850 million in 2004. The decline in securitization related revenue in 2006 and 2005 was due todecreases in the level of securitized receivables and higher run-off due toshorter expected lives of securitization trusts as a result of our decision inthe third quarter of 2004 to structure all new collateralized fundingtransactions as secured financings. Because existing public credit cardtransactions were structured as sales to revolving trusts that requirereplenishments of receivables to support previously issued securities,receivables continue to be sold to these trusts until the revolving periods end,the last of which is currently projected to occur in the fourth quarter of 2007.We will continue to replenish at reduced levels, certain non-public personalnon-credit card securities issued to conduits and record the resultingreplenishment gains for a period of time in order to manage liquidity. While thetermination of sale treatment on new collateralized funding activity and thereduction of sales under replenishment agreements reduced our reported netincome under U.S. GAAP, there is no impact on cash received from operations. See Note 2, "Summary of Significant Accounting Policies," and Note 8, "AssetSecuritizations," to the accompanying consolidated financial statements and "OffBalance Sheet Arrangements and Secured Financings" for further information onasset securitizations. Insurance revenue increased in 2006 primarily due to higher sales volumes andnew reinsurance activity beginning in the third quarter of 2006 in our domesticoperations. These increases in 2006 were partially offset by lower insurancesales volumes in our U.K. operations. The increase in 2005 was due to increasedsales volumes for many of our insurance products in both our U.K. and domesticoperations. 51 HSBC Finance Corporation-------------------------------------------------------------------------------- Investment income, which includes income on securities available for sale in ourinsurance business and realized gains and losses from the sale of securities,increased in 2006 primarily due to the $123 million gain on sale of ourinvestment in Kanbay. In 2005, the lower average investment balances and lowergains from security sales were largely offset by higher yields on ourinvestments. Derivative income, which includes realized and unrealized gains and losses onderivatives which do not qualify as effective hedges under SFAS No. 133 as wellas the ineffectiveness on derivatives associated with our qualifying hedges issummarized in the table below: 2006 2005 2004-------------------------------------------------------------------------------- (IN MILLIONS) Net realized gains (losses)................................. $ (7) $ 52 $ 68Mark-to-market on derivatives which do not qualify as effective hedges.......................................... 28 156 442Ineffectiveness............................................. 169 41 1 ---- ---- ----Total....................................................... $190 $249 $511 ==== ==== ==== In 2006, derivative income decreased primarily due to a significant reductionduring 2005 in the population of interest rate swaps which do not qualify forhedge accounting under SFAS No. 133. In addition, during 2006 we haveexperienced a rising interest rate environment compared to a yield cure thatgenerally flattened in the comparable period of 2005. The income fromineffectiveness in both periods resulted from the designation during 2005 of asignificant number of our derivatives as effective hedges under the long-haulmethod of accounting. These derivatives had not previously qualified for hedgeaccounting under SFAS No. 133. In addition, all of the hedge relationships whichqualified under the shortcut method provisions of SFAS No. 133 have now beenredesignated, substantially all of which are hedges under the long-haul methodof accounting. Redesignation of swaps as effective hedges reduces the overallvolatility of reported mark-to-market income, although establishing such swapsas long-haul hedges creates volatility as a result of hedge ineffectiveness. Allderivatives are economic hedges of the underlying debt instruments regardless ofthe accounting treatment. Net income volatility, whether based on changes in interest rates for swapswhich do not qualify for hedge accounting or ineffectiveness recorded on ourqualifying hedges under the long haul method of accounting, impacts thecomparability of our reported results between periods. Accordingly, derivativeincome for the year ended December 31, 2006 should not be considered indicativeof the results for any future periods. Fee income, which includes revenues from fee-based products such as creditcards, increased in 2006 and 2005 due to higher credit card fees, particularlyrelating to our non-prime credit card portfolio due to higher levels of creditcard receivables, including the Metris portfolio acquired in December 2005 andin 2005, improved interchange rates. Increases in 2006 were partially offset bythe impact of FFIEC guidance which limits certain fee billings for non-primecredit card accounts and higher rewards program expenses. Increases in 2005 werepartially offset by lower private label credit card fees and higher rewardsprogram expenses. The lower private label credit card fees were the result ofthe bulk sale of domestic private label receivables to HSBC Bank USA in December2004. Enhancement services revenue, which consists of ancillary credit card revenuefrom products such as Account Secure Plus (debt waiver) and Identity ProtectionPlan, was higher in 2006 and 2005 primarily as a result of higher levels ofcredit card receivables and higher customer acceptance levels. Additionally, theacquisition of Metris in December 2005 contributed to higher enhancementservices revenue in 2006. Taxpayer financial services ("TFS") revenue decreased as 2005 TFS revenuesreflects gains of $24 million on the sales of certain bad debt recovery rightsto a third party. Excluding the impact of these gains in the prior year, TFSrevenue increased due to increased loan volume during the 2006 tax season. Theincrease in 2005 was a result of increased loan volume in the 2005 tax season aswell as the gains on the sale of bad debt recovery rights discussed above. 52 HSBC Finance Corporation-------------------------------------------------------------------------------- Gain on bulk sale of private label receivables resulted from the sale of $12.2billion of domestic private label receivables including the retained interestsassociated with securitized private label receivables to HSBC Bank USA inDecember 2004. See Note 4, "Sale of Domestic Private Label Receivable Portfolioand Adoption of FFIEC Policies," to the accompanying consolidated financialstatements for further information. Gains on receivable sales to HSBC affiliates in 2006 and 2005 includes the dailysales of domestic private label receivable originations (excluding retail salescontracts) and certain credit card account originations to HSBC Bank USA as wellas gains on bulk sales of real estate secured receivables to HSBC Bank USA byour Decision One mortgage operations in 2006. In 2004, gains on receivable salesto HSBC affiliates includes the bulk sale of real estate secured receivables inMarch 2004 as well as certain credit card account originations to HSBC Bank USA.See Note 4, "Sale of Domestic Private Label Receivable Portfolio and Adoption ofFFIEC Policies," to the accompanying consolidated financial statements forfurther information. Servicing fees from HSBC affiliates represents revenue received under servicelevel agreements under which we service credit card and domestic private labelreceivables as well as real estate secured and auto finance receivables for HSBCaffiliates. The increases primarily relate to higher levels of receivables beingserviced on behalf of HSBC Bank USA and in 2006 the servicing fees we receivefor servicing the credit card receivables sold to HBEU in December 2005. Other income decreased in 2006 primarily due to lower gains on sales of realestate secured receivables by our Decision One mortgage operations and anincrease in the liability for estimated losses from indemnification provisionson Decision One loans previously sold. Lower gains on miscellaneous asset sales,including real estate investments also contributed to the decrease in otherincome. The increase in 2005 was primarily due to higher gains on miscellaneousasset sales, including the sale of a real estate investment. COSTS AND EXPENSES The following table summarizes total costs and expenses: YEAR ENDED DECEMBER 31, 2006 2005 2004-------------------------------------------------------------------------------------- (IN MILLIONS) Salaries and employee benefits.............................. $2,333 $2,072 $1,886Sales incentives............................................ 358 397 363Occupancy and equipment expenses............................ 317 334 323Other marketing expenses.................................... 814 731 636Other servicing and administrative expenses................. 1,115 917 958Support services from HSBC affiliates....................... 1,087 889 750Amortization of intangibles................................. 269 345 363Policyholders' benefits..................................... 467 456 412 ------ ------ ------Total costs and expenses.................................... $6,760 $6,141 $5,691 ====== ====== ====== Salaries and employee benefits increased in 2006 and 2005 as a result ofadditional staffing, primarily in our Consumer Lending, Mortgage Services,Retail Services and Canadian operations as well as in our corporate functions tosupport growth. Salaries in 2006 were also higher due to additional staffing inour Credit Card Services operations as a result of the acquisition of Metris inDecember 2005 which was partially offset by lower staffing levels in our U.K.business as a result of the sale of the cards business in 2005. Effective December 20, 2005, our U.K. based technology services employees weretransferred to HBEU. As a result, operating expenses relating to informationtechnology, which were previously reported as salaries and fringe benefits, arenow billed to us by HBEU and reported as support services from HSBC affiliates. Sales incentives decreased in 2006 due to lower origination volumes in ourMortgage Services business due to the decision to reduce purchases includingsecond lien and selected higher risk products in the second half of 2006. Alsocontributing to the decrease in 2006 was lower volumes in our U.K. businesspartially offset by 53 HSBC Finance Corporation-------------------------------------------------------------------------------- increases in our Canadian operations. Sales incentives increased in 2005 due tohigher volumes in both our Consumer Lending and Mortgage Services businesses. Occupancy and equipment expenses decreased in 2006 as a result of the sale ofour U.K. credit card business in December 2005 which included the leaseassociated with the credit card call center as well as lower repairs andmaintenance costs. These decreases were partially offset by higher occupancy andequipment expenses resulting from our acquisition of Metris in December 2005.Occupancy and equipment expenses increased in 2005 as higher occupancy expenseand higher repairs and maintenance costs were partially offset by lowerdepreciation. Other marketing expenses includes payments for advertising, direct mail programsand other marketing expenditures. The increase in 2006 was primarily due toincreased domestic credit card marketing expense including the Metris portfolioacquired in December 2005, and expenses related to the launch of a co-brandcredit card in the third quarter of 2006, partially offset by decreased expensesin our U.K. operations as a result of the sale of our U.K. card business inDecember 2005. The increase in 2005 was primarily due to increased domesticcredit card marketing expenses due to higher non-prime marketing expense andinvestments in new marketing initiatives. Changes in contractual marketingresponsibilities in July 2004 associated with the General Motors ("GM")co-branded credit card also resulted in increased expenses in 2005. Other servicing and administrative expenses increased in 2006 as a result ofhigher REO expenses due to higher volumes and higher losses, higher systemscosts and higher insurance operating expense in our U.K. operations. Theincrease in 2006 also reflects lower deferred origination costs at our MortgageServices business due to lower volumes. Other servicing and administrativeexpenses decreased in 2005 due to lower REO expenses and a lower estimate ofexposure relating to accrued finance charges associated with certain loanrestructures which were partially offset by higher systems costs. Support services from HSBC affiliates, which includes technology and otherservices charged to us by HTSU since January 1, 2004 and by HBEU since December20, 2005, increased in 2006 and 2005 primarily due to growth. Amortization of intangibles decreased in 2006 and 2005 due to lower intangibleamortization related to our purchased credit card relationships due to acontract renegotiation with one of our co-branded credit card partners in 2005and lower amortization associated with an individual contractual relationship.These decreases in 2006 were partially offset by amortization expense associatedwith the Metris cardholder relationships. Additionally, 2006 amortizationexpense was lower following the sale of the U.K. card business in 2005 and thewrite-off related to a trade name in the U.K. in 2005. Policyholders' benefits increased in 2006 due to higher sales volumes and newreinsurance activity in our domestic operations beginning in the third quarterof 2006, partially offset by decreased sales volumes in our U.K. operations aswell as lower amortization of fair value adjustments relating to our insurancebusiness. Policyholders' benefits increased in 2005 due to a continuing increasein insurance sales volumes in both our U.K. and domestic operations, partiallyoffset by lower amortization of fair value adjustments relating to our insurancebusiness. The following table summarizes our efficiency ratio: YEAR ENDED DECEMBER 31, 2006 2005 2004--------------------------------------------------------------------------------------- U.S. GAAP basis efficiency ratio............................ 41.55% 44.10% 42.05%Operating basis efficiency ratio(1)......................... 41.89 44.10 43.84 --------------- (1) Represents a non-U.S. GAAP financial measure. See "Basis of Reporting" for additional discussion on the use of this non-U.S. GAAP financial measure and "Reconciliations to U.S. GAAP Financial Measures" for quantitative reconciliations of our operating efficiency ratio to our owned basis U.S. GAAP efficiency ratio. 54 HSBC Finance Corporation-------------------------------------------------------------------------------- Our efficiency ratios improved due to higher net interest income and higher feeincome and enhancement services revenues due to higher levels of receivables,partially offset by an increase in total costs and expenses to supportreceivable growth as well as higher losses on REO properties. Our efficiencyratio in 2005 was significantly impacted by the results of the domestic privatelabel receivable portfolio which was sold in December 2004. Excluding theresults of this domestic private label portfolio from both the 2005 and 2004periods, our 2005 efficiency ratio improved 259 basis points as compared to2004. This improvement is primarily a result of higher net interest income andother revenues due to higher levels of owned receivables, partially offset bythe increase in total costs and expenses to support receivable growth. INCOME TAXES Our effective tax rates were as follows: YEAR ENDED DECEMBER 31, EFFECTIVE TAX RATE-------------------------------------------------------------------------------- 2006........................................................ 36.9%2005........................................................ 33.52004........................................................ 34.0 The increase in the effective tax rate for 2006 was due to higher state incometaxes and lower tax credits as a percentage of income before taxes. The increasein state income taxes was primarily due to an increase in the blended statutorytax rate of our operating companies. The decrease in the effective tax rate in2005 is attributable to lower state tax rates and lower pretax income with lowincome housing tax credits remaining constant. The effective tax rate differsfrom the statutory federal income tax rate primarily because of the effects ofstate and local income taxes and tax credits. SEGMENT RESULTS - IFRS MANAGEMENT BASIS-------------------------------------------------------------------------------- We have three reportable segments: Consumer, Credit Card Services andInternational. Our Consumer segment consists of our Consumer Lending, MortgageServices, Retail Services and Auto Finance businesses. Our Credit Card Servicessegment consists of our domestic MasterCard and Visa and other credit cardbusiness. Our International segment consists of our foreign operations in theUnited Kingdom, Canada, the Republic of Ireland, and prior to November 2006 ouroperations in Slovakia, the Czech Republic and Hungary. The composition of our business segments is consistent with that reported in our2005 Form 10-K. However, as previously discussed, corporate goals and individualgoals of executives are currently calculated in accordance with IFRSs underwhich HSBC prepares its consolidated financials statements. In 2006 we initiateda project to refine the monthly internal management reporting process to place agreater emphasis on IFRS Management Basis reporting (a non-U.S. GAAP financialmeasure). As a result, operating results are now monitored and reviewed, trendsare being evaluated and decisions about allocating resources, such as employees,are now being made almost exclusively on an IFRS Management Basis. As previouslydiscussed, IFRS Management Basis results are IFRSs results which assume that theprivate label and real estate secured receivables transferred to HSBC Bank USAhave not been sold and remain on our balance sheet. Operations are monitored andtrends are evaluated on an IFRS Management Basis because the customer loan salesto HSBC Bank USA were conducted primarily to appropriately fund prime customerloans within HSBC and such customer loans continue to be managed and serviced byus without regard to ownership. Therefore, we have changed the measurement ofsegment profit to an IFRS Management Basis in order to align with our revisedinternal reporting structure. However, we continue to monitor capital adequacy,establish dividend policy and report to regulatory agencies on an U.S. GAAPbasis. A summary of the significant differences between U.S. GAAP and IFRSs asthey impact our results are summarized in Note 21, "Business Segments," in theaccompanying consolidated financial statements. For comparability purposes, we have restated segment results for the year endedDecember 31, 2005 to the IFRS Management Basis. When HSBC began reporting IFRSresults in 2005, it elected to take advantage of certain options availableduring the year of transition from U.K. GAAP to IFRSs which provided, among 55 HSBC Finance Corporation-------------------------------------------------------------------------------- other things, an exemption from applying certain IFRSs retrospectively.Therefore, the segment results reported for the year ended December 31, 2004 arepresented on an IFRS Management Basis excluding the retrospective application ofIAS 32, "Financial Instruments: Presentation" and IAS 39, "FinancialInstruments: Recognition and Measurement" which took effect on January 1, 2005and, as a result, the accounting for credit loss impairment provisioning,deferred loan origination costs and premiums and derivative income for the yearended December 31, 2004 remain in accordance with U.K. GAAP, HSBC's previousbasis of reporting. Credit loss provisioning under U.K. GAAP differs from IFRSsin that IFRSs require a discounted cash flow methodology for estimatingimpairment as well as accruing for future recoveries of charged-off loans on adiscounted basis. Under U.K. GAAP, only sales incentives were treated asdeferred loan origination costs which results in lower deferrals than thosereported under IFRSs. Additionally, deferred costs and fees could be amortizedover the contractual life of the underlying receivable rather than the expectedlife as required under IFRSs. Derivative and hedge accounting under U.K. GAAPdiffers from U.S. GAAP in many respects, including the determination of when ahedge exists as well as the reporting of gains and losses. For a more detaileddiscussion of the differences between IFRSs and U.K. GAAP, see Exhibit 99.2 tothis Form 10-K. CONSUMER SEGMENT The following table summarizes the IFRS Management Basisresults for our Consumer segment for the years ended December 31, 2006, 2005 and2004. YEAR ENDED DECEMBER 31, 2006 2005 2004-------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net income.................................................. $ 988 $ 1,981 $ 1,737Operating net income........................................ 988 1,981 1,324Net interest income......................................... 8,588 8,401 8,180Other operating income...................................... 909 814 502Intersegment revenues....................................... 242 108 101Loan impairment charges..................................... 4,983 3,362 3,151Operating expenses.......................................... 2,998 2,757 2,777Customer loans.............................................. 144,573 128,095 107,769Assets...................................................... 146,395 130,375 109,238Net interest margin......................................... 6.23% 7.15% 8.38%Return on average assets.................................... .71 1.68 1.77 2006 compared to 2005 Our Consumer segment reported lower net income in 2006 dueto higher loan impairment charges and operating expenses, partially offset byhigher net interest income and higher other operating income. Loan impairment charges for the Consumer segment increased significantly during2006. The increase in loan impairment charges was largely driven bydeterioration in the performance of mortgage loans acquired in 2005 and 2006 byour Mortgage Services business, particularly in the second lien and portions ofthe first lien portfolios which has resulted in higher delinquency, charge-offand loss estimates in these portfolios. These increases were partially offset bya reduction in the estimated loss exposure resulting from Katrina ofapproximately $68 million in 2006 as well as the benefit of low unemploymentlevels in the United States. In 2006, we increased loss reserve levels as theprovision for credit losses was greater than net charge-offs by $1,597 million,which included $1,627 million related to our Mortgage Services business. Operating expenses were higher in 2006 due to lower deferred loan originationcosts in our Mortgage Services business as mortgage origination volumes havedeclined, higher marketing expenses due to the launch of a new co-brand creditcard in our Retail Services business, higher salary expense and higher supportservices from affiliates to support growth. Net interest income increased during 2006 primarily due to higher averagecustomer loans and higher overall yields, partially offset by higher interestexpense. Overall yields reflect strong growth in real estate secured 56 HSBC Finance Corporation-------------------------------------------------------------------------------- customer loans at current market rates and a higher mix of higher yieldingsecond lien real estate secured loans and personal non-credit card customerloans due to growth. These increases were partially offset by a reduction in netinterest income of $120 million due to an adjustment to recognize prepaymentpenalties on real estate secured loans over the expected life of the product.Net interest margin decreased from the prior year as the higher yields discussedabove were offset by higher interest expense due to a larger balance sheet and asignificantly higher cost of funds resulting from a rising interest rateenvironment. The increase in other operating income in 2006 was primarily due to highercredit insurance commissions, higher late fees and a higher fair valueadjustment for our loans held for sale, partially offset by higher REO expensedue to higher volumes and losses. Customer loans increased 13 percent to $144.6 billion at December 31, 2006 ascompared to $128.1 billion at December 31, 2005. Real estate growth in 2006 wasstrong as a result of strong growth in our branch-based Consumer Lendingbusiness. In addition, our correspondent business experienced growth during thefirst six months of 2006 as management continued to focus on junior lien loansand expanded our sources for purchasing newly originated loans from flowcorrespondents. However, in the second half of 2006, management revised itsbusiness plan and began tightening underwriting standards on loans purchasedfrom correspondents including reducing purchases of second lien and selectedhigher risk segments. These activities have reduced, and will continue toreduce, the volume of correspondent purchases in the future which will have theeffect of slowing growth in the real estate secured portfolio. Growth in ourbranch-based Consumer Lending business reflects higher sales volumes than in theprior year as we continue to emphasize real estate secured loans, including anear-prime mortgage product we first introduced in 2003. Real estate securedcustomer loans also increased as a result of portfolio acquisitions, includingthe $2.5 billion of customer loans related to the Champion portfolio purchasedin November 2006 as well as $.4 billion in 2006 and $1.7 billion in 2005 ofpurchases from a portfolio acquisition program. In addition, a decline in loanprepayments in 2006 resulted in lower run-off rates for our real estate securedportfolio which also contributed to overall growth. Our Auto Finance businessalso reported organic growth, principally in the near-prime portfolio, fromincreased volume in both the dealer network and the consumer direct loanprogram. The private label portfolio increased in 2006 due to strong growthwithin consumer electronics and powersports as well as new merchant signings.Growth in our personal non-credit card portfolio was the result of increasedmarketing, including several large direct mail campaigns. In the fourth quarter of 2006, our Consumer Lending business completed theacquisition of Solstice Capital Group Inc. ("Solstice") with assets ofapproximately $49 million, in an all cash transaction for approximately $50million. Additional consideration may be paid based on Solstice's 2007 pre-taxincome. Solstice markets a range of mortgage and home equity products tocustomers through direct mail. This acquisition will add momentum to ourorigination growth plan by providing an additional channel to customers. ROA was .71 percent in 2006 and 1.68 percent in 2005. The decrease in the ROAratio in 2006 is due to the decrease in net income discussed above as well asthe growth in average assets. In accordance with Federal Financial Institutions Examination Council ("FFIEC")guidance, the required minimum monthly payment amounts for domestic privatelabel credit card accounts have changed. The implementation of these newrequirements began in the fourth quarter of 2005 and was completed in the firstquarter of 2006. Implementation did not have a material impact on either theresults of the Consumer segment or our consolidated results. 2005 compared to 2004 Our Consumer segment reported higher operating net incomein 2005. Operating net income is a non-U.S. GAAP financial measure of net incomewhich excludes in 2004 the $97 million decrease in net income relating to theadoption of FFIEC charge-off policies for our domestic private label customerloans (excluding the retail sales contracts at our Consumer Lending business).In 2005, the increase in operating net income was primarily due to higher otheroperating income and higher net interest income, partially offset by higher loanimpairment charges. 57 HSBC Finance Corporation-------------------------------------------------------------------------------- The increase in other operating income was due to higher late and other accountservices fees and lower losses on REO properties. Additionally, as IAS 39 wasnot adopted until January 1, 2005, other operating income in 2005 includesamounts which were classified differently in 2004. Under IAS 39, interest incomeand deferred loan origination fees for loans held for sale are recorded astrading income and included in other operating income. In 2004 under U.K. GAAP,these items were not included in other operating income but continued to bereported as components of interest income and deferred loan origination fees.Therefore, the 2005 results include $79 million in other operating income forloans held for sale for which the comparable 2004 amounts were included ininterest income and deferred loan origination fees in 2004. Net interest income increased in 2005 primarily due to higher average customerloans, partially offset by higher interest expense. Net interest margindecreased in 2005 as a result of lower yields on real estate secured and autofinance customer loans as a result of competitive pressure on pricing andproduct expansion into near-prime consumer segments, as well as the run-off ofhigher yielding real estate secured customer loans, including second lien loans,largely due to refinance activity. Our Auto Finance business experienced loweryields as we targeted higher credit quality customers. Although higher creditquality customer loans generate lower yields, such customer loans are expectedto result in lower operating costs, delinquency ratios and charge-off. Thedecreases in yield for our consumer segment receivable portfolio discussed abovewere partially offset by higher pricing on our variable rate products. A highercost of funds due to a rising interest rate environment also contributed to thedecrease in net interest margin. Loan impairment charges increased in 2005 as a result of increased provisionrequirements associated with receivable growth, the impact from Katrina and thenew bankruptcy law in the United States, which are discussed more fully below.Excluding the impact of Katrina and the new bankruptcy law in the United States,loan impairment charges were lower in 2005 driven by lower net charge-off due toimproved credit quality, partially offset by increased provision requirementsdue to portfolio growth. In 2005 we experienced lower dollars of net charge-offsthan in the prior year. In 2005, we increased IFRS Management Basis lossreserves as the provision for credit losses was higher than net charge-offs by$261 million. As previously mentioned, loan impairment charges in 2005 also reflected anestimate of incremental credit loss exposure relating to Katrina. Theincremental provision for credit losses for Katrina in the Consumer segment in2005 was $130 million and represented our best estimate of Katrina's impact onour loan portfolio. In an effort to assist our customers affected by thedisaster, we initiated various programs including extended payment arrangementsfor up to 90 days or more depending upon customer circumstances. These interestand fee waivers were not material to the Consumer segment's 2005 results. As previously discussed, the United States enacted new bankruptcy legislationwhich resulted in a spike in bankruptcy filings prior to the October 2005effective date. As a result, our 2005 fourth quarter results included anincrease of approximately $130 million in loan impairment charges due to thisspike in bankruptcy filings. However, in accordance with our charge-off policyfor real estate secured and personal non-credit card customer loans, theassociated accounts did not begin to migrate to charge-off until 2006. Customer loans increased 19 percent to $128.1 billion at December 31, 2005 ascompared to $107.8 billion at December 31, 2004. We experienced strong growth in2005 in our real estate secured portfolio in both our correspondent andbranch-based businesses. In 2005 we continued to focus on junior lien loansthrough portfolio acquisitions and expanded our sources for purchasing newlyoriginated loans from flow correspondents. Growth in real estate securedcustomer loans was also supplemented by purchases from a single correspondentrelationship which totaled $1.1 billion in 2005. Also contributing to theincrease were purchases of $1.7 billion in 2005 from a portfolio acquisitionprogram. Our auto finance portfolio also reported growth due to strong organicgrowth, principally in the near-prime portfolios. This came from newlyoriginated loans acquired from our dealer network, growth in the consumer directloan program and expanded distribution through alliance channels. Our privatelabel portfolio experienced growth as a result of strong merchant renewalsincluding nine new retail merchants in 2005 as well as an increase in thecommercial card capacity. Personal non-credit card customer loans increased fromthe prior year as we began to increase the availability 58 HSBC Finance Corporation-------------------------------------------------------------------------------- of this product in the second half of 2004 as a result of an improving U.S.economy as well as the success of several large direct mail campaigns thatoccurred in 2005. ROA was 1.68 percent in 2005 and 1.77 percent in 2004. The decrease in 2005 wasa result of the growth in average assets outpacing the increase in net income. CREDIT CARD SERVICES SEGMENT The following table summarizes the IFRS ManagementBasis results for our Credit Card Services segment for the years ended December31, 2006, 2005 and 2004. YEAR ENDED DECEMBER 31, 2006 2005 2004----------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net income.................................................. $ 1,386 $ 813 $ 521Net interest income......................................... 3,151 2,150 2,226Other operating income...................................... 2,360 1,892 1,581Intersegment revenues....................................... 20 21 25Loan impairment charges..................................... 1,500 1,453 1,786Operating expenses.......................................... 1,841 1,315 1,205Customer loans.............................................. 28,221 25,979 19,615Assets...................................................... 28,780 28,453 19,702Net interest margin......................................... 11.85% 10.42% 10.78%Return on average assets.................................... 5.18 4.13 2.55 2006 compared to 2005 Our Credit Card Services segment reported higher netincome in 2006. The increase in net income was primarily due to higher netinterest income and higher other operating income, partially offset by higheroperating expenses and higher loan impairment charges. The acquisition ofMetris, which was completed in December 2005, contributed $147 million of netincome during 2006 as compared to $4 million in 2005. Net interest income increased in 2006 largely as a result of the Metrisacquisition, which contributed to higher overall yields due in part to higherlevels of non-prime customer loans, partially offset by higher interest expense.Net interest income in 2006 also benefited from the implementation in the secondquarter of 2006 of a methodology for calculating the effective interest rate forintroductory rate credit card customer loans under IFRSs over the expected lifeof the product which increased net interest income by $154 million for the year.Net interest margin increased primarily due to higher overall yields due toincreases in non-prime customer loans, including the customer loans acquired aspart of Metris, higher pricing on variable rate products and other repricinginitiatives. These increases were partially offset by a higher cost of funds.Net interest margin in 2006 was also positively impacted by the adjustmentsrecorded for the effective interest rate for introductory rate MasterCard/Visacustomer loans discussed above. Although our non-prime customer loans tend tohave smaller balances, they generate higher returns both in terms of netinterest margin and fee income. Increases in other operating income resulted from portfolio growth, includingthe Metris portfolio acquired in December 2005 which has resulted in higher latefees, higher interchange revenue and higher enhancement services revenue fromproducts such as Account Secure Plus (debt waiver) and Identity Protection Plan.This increase in fee income was partially offset by adverse impacts of limitingcertain fee billings on non-prime credit card accounts as discussed below. Higher operating expenses were incurred to support receivable growth, includingthe Metris portfolio acquisition, and increases in marketing expenses. Theincrease in marketing expenses in 2006 was primarily due to the Metris portfolioacquired in December 2005 and increased investment in our non-prime portfolio. Loan impairment charges were higher in 2006. Loan impairment charges in 2005were impacted by incremental credit loss provisions relating to the spike inbankruptcy filings experienced in the period leading up to October 17, 2005,which was the effective date of new bankruptcy laws in the United States andhigher 59 HSBC Finance Corporation-------------------------------------------------------------------------------- provisions relating to Katrina. Excluding these items, provisions in 2006nonetheless increased, reflecting receivable growth and portfolio seasoning,including the full year impact of the Metris portfolio, partially offset by theimpact of lower levels of bankruptcy filings following the enactment of newbankruptcy laws in October 2005, higher recoveries as a result of better ratesavailable in the non-performing asset sales market and a reduction of ourestimate of incremental credit loss exposure related to Katrina of approximately$26 million. We increased loss reserves by recording loss provision greater thannet charge-off of $328 million in 2006. Customer loans increased 9 percent to $28.2 billion at December 31, 2006compared to $26.0 billion at December 31, 2005. The increase reflects strongdomestic organic growth in our Union Privilege as well as other non-primeportfolios including Metris. The increase in ROA in 2006 is primarily due to the higher net income asdiscussed above, partially offset by higher average assets. In accordance with FFIEC guidance, our Credit Card Services business adopted aplan to phase in changes to the required minimum monthly payment amount andlimit certain fee billings for non-prime credit card accounts. Theimplementation of these new requirements began in July 2005 with therequirements fully phased in by December 31, 2005. These changes resulted inlower non-prime credit card fee income in 2006. In addition, roll rate trends inthe prime book have been slightly higher than those experienced prior to thechanges in minimum payment. These changes have resulted in fluctuations in loanimpairment charges as credit loss provisions for prime accounts has increased asa result of higher required monthly payments while the non-prime provisiondecreased due to lower levels of fees incurred by customers. The impact of thesechanges has not had a material impact on our consolidated results, but has had amaterial impact to the Credit Card Services segment in 2006. 2005 compared to 2004 Our Credit Card Services segment reported higher netincome in 2005. The increase in net income was primarily due to higher otheroperating income and lower loan impairment charges, partially offset by higheroperating expenses and lower net interest income. The acquisition of Metris,which was completed in December 2005, did not have a significant impact to theresults of the Credit Card Services segment in 2005. Increases in otheroperating income resulted from portfolio growth, higher late and overlimit feesand improved interchange rates. Loan impairment charges decreased in 2005 due to improved credit quality,partially offset by receivable growth as well as the increased credit lossprovision relating to the impact of Katrina and the increased bankruptcy filingsresulting from the new bankruptcy law in the United States. We experiencedhigher dollars of net charge-offs in our portfolio due to higher receivablelevels as well as the increased credit card charge-offs in the fourth quarter of2005 which resulted from the spike in bankruptcy filings prior to the October2005 effective date of the new bankruptcy law. We had been maintaining creditloss reserves in anticipation of the impact this new law would have on netcharge-offs. However, the magnitude of the spike in bankruptcies experiencedimmediately before the new law became effective was larger than anticipatedwhich resulted in an additional $100 million credit loss provision beingrecorded during the third quarter of 2005. Our fourth quarter of 2005 resultsincluded an estimated $125 million in incremental charge-offs of principal,interest and fees attributable to bankruptcy reform which was offset by arelease of our owned credit loss reserves of $125 million. As expected, thenumber of bankruptcy filings subsequent to the enactment of this new law hasdecreased dramatically. In 2005, we increased our loss reserves by recordingloss provision greater than net charge-offs of $20 million. Loan impairment charges in 2005 also reflects an estimate of incremental creditloss exposure relating to Katrina. The incremental provision for credit lossesfor Katrina in the Credit Card Services segment in 2005 was $55 million andrepresented our best estimate of Katrina's impact on our loan portfolio. In aneffort to assist our customers affected by the disaster, we initiated variousprograms including extended payment arrangements and interest and fee waiversfor up to 90 days or more depending upon customer circumstances. These interestand fee waivers were not material to the Credit Card Services segment's 2005results. 60 HSBC Finance Corporation-------------------------------------------------------------------------------- Higher operating expenses were to support receivable growth and increases inmarketing expenses. The increase in marketing expenses was due to highernon-prime marketing expense, investments in new marketing initiatives andchanges in contractual marketing responsibilities in July 2004 associated withthe domestic co-branded GM credit card. Net interest income decreased due to higher interest expense in 2005 due to ahigher cost of funds, partially offset by increases in finance and interestincome. The increase in finance and interest income from our credit cardcustomer loans reflects increased pricing on variable yield products and higherreceivable balances. Yields increased in 2005 primarily due to increases innon-prime receivable levels, higher pricing on variable rate products as well asother repricing initiatives. Lower average interest earning assets due to lowerlevels of low yielding investment securities and the impact of loweramortization from receivable origination costs resulting from changes in thecontractual marketing responsibilities in July 2004 associated with the co-branded GM credit card also contributed to the increase in yield. Theseincreases to net interest margin were offset by higher interest expenseresulting in lower net interest margin. Although our non-prime customer loanstend to have smaller balances, they generate higher returns both in terms of netinterest margin and fee income. Customer loans increased 32 percent to $26.0 billion at December 31, 2005compared to $19.6 billion at December 31, 2004. As discussed above, the increasewas primarily due to the acquisition of Metris in December 2005 which increasedcustomer loans by $5.3 billion on an IFRS Management Basis. Organic growth inour HSBC branded prime, Union Privilege and non-prime portfolios, partiallyoffset by the continued decline in certain older acquired portfolios, alsocontributed to the increase. The increase in ROA in 2005 was primarily due to the higher net income discussedabove as well as the impact of lower average assets. The decrease in averageassets was due to lower investment securities during 2005 as a result of theelimination of investments dedicated to our credit card bank in 2003 resultingfrom our acquisition by HSBC. INTERNATIONAL SEGMENT The following table summarizes the IFRS Management Basisresults for our International segment for the years ended December 31, 2006,2005 and 2004. YEAR ENDED DECEMBER 31, 2006 2005 2004----------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net income.................................................. $ 42 $ 481 $ 122Net interest income......................................... 826 971 899Gain on sales to affiliates................................. 29 464 -Other operating income, excluding gain on sales to affiliates................................................ 254 306 313Intersegment revenues....................................... 33 17 15Loan impairment charges..................................... 535 620 408Operating expenses.......................................... 495 635 615Customer loans.............................................. 9,520 9,328 13,102Assets...................................................... 10,764 10,905 14,263Net interest margin......................................... 8.22% 7.35% 7.57%Return on average assets.................................... .37 3.52 .98 2006 compared to 2005 Our International segment reported lower net income in2006. However, net income in 2006 includes the $29 million gain on the sale ofthe European Operations to HBEU and in 2005 includes the $464 million gain onthe sale of the U.K. credit card business to HBEU. As discussed more fullybelow, the gains reported by the International segment exclude the write-off ofgoodwill and intangible assets associated with these transactions. Excluding thegain on sale from both periods, the International segment reported higher netincome in 2006 primarily due to lower loan impairment charges and loweroperating expenses, partially offset by lower net interest income and lowerother operating income. Applying constant 61 HSBC Finance Corporation-------------------------------------------------------------------------------- currency rates, which uses the average rate of exchange for 2005 to translatecurrent period net income, the net income in 2006 would have been lower by $2million. Loan impairment charges decreased in 2006 primarily due to the sale of our U.K.credit card business partially offset by increases due to the deterioration ofthe financial circumstances of our customers across the U.K. and increases atour Canadian business due to receivable growth. We increased loss reserves byrecording loss provision greater than net charge-offs of $3 million in 2006. Operating expenses decreased as a result of the sale of our U.K. credit cardbusiness in December 2005. The decrease in operating expenses was partiallyoffset by increased costs associated with growth in the Canadian business. Net interest income decreased during 2006 primarily as a result of lowerreceivable levels in our U.K. subsidiary. The lower receivable levels were dueto the sale of our U.K. credit card business in December 2005, including $2.5billion in customer loans, to HBEU as discussed more fully below, as well asdecreased sales volumes in the U.K. resulting from a continuing challengingcredit environment in the U.K. This was partially offset by higher net interestincome in our Canadian operations due to growth in customer loans. Net interestmargin increased in 2006 primarily due to lower cost of funds partially offsetby the change in receivable mix resulting from the sale of our U.K. credit cardbusiness in December 2005. Other operating income decreased in 2006, in part, due to the aforementionedsale of the U.K. credit card business which resulted in lower credit card feeincome partially offset by higher servicing fee income from affiliates. Otheroperating income was also lower in 2006 due to lower income from our insuranceoperations. Customer loans of $9.5 billion at December 31, 2006 increased 2 percent comparedto $9.3 billion at December, 2005. Our Canadian operations experienced stronggrowth in its receivable portfolios. Branch expansions, the addition of 1,000new auto dealer relationships and the successful launch of a MasterCard creditcard program in Canada in 2005 have resulted in growth in both the secured andunsecured receivable portfolios. The increases in our Canadian portfolio werepartially offset by lower customer loans in our U.K. operations. Our U.K. basedunsecured customer loans decreased due to continuing lower retail sales volumefollowing a slow down in retail consumer spending as well as the sale of $203million of customer loans related to our European operations in November 2006 asdiscussed more fully below. Applying constant currency rates, which uses theDecember 31, 2005 rate of exchange to translate current customer loan balances,customer loans would have been lower by $708 million at December 31, 2006. ROA was .37 percent in 2006 and 3.52 percent in 2005. These ratios have beenimpacted by the gains on asset sales to affiliates. Excluding the gain on salefrom both periods, ROA was essentially flat as ROA was .11 percent in 2006 and.12 percent in 2005. As previously disclosed, in November 2006, we sold the capital stock of ouroperations in the Czech Republic, Hungary, and Slovakia to a wholly ownedsubsidiary of HBEU, a U.K. based subsidiary of HSBC, for an aggregate purchaseprice of approximately $46 million. The International segment recorded a gain onsale of $29 million as a result of this transaction. As the fair valueadjustments related to purchase accounting resulting from our acquisition byHSBC and the related amortization are allocated to Corporate, which is includedin the "All Other" caption within our segment disclosures, the gain recorded inthe International segment does not include the goodwill write-off resulting fromthis transaction of $15 million on an IFRS Management Basis. We continue toevaluate the scope of our other U.K. operations. 2005 compared to 2004 Our International segment reported higher net income in2005. However, net income in 2005 includes the $464 million gain on the sale ofthe U.K. credit card business to HBEU. As discussed more fully below, the gainreported by the International segment excludes the write-off of goodwill andintangible assets associated with these transactions. Excluding the gain on salefrom 2005, the International segment reported lower net income driven by asignificant decline in earnings at our U.K. subsidiary. Overall, the decreasereflects higher loan impairment charges and higher operating expenses, partiallyoffset by higher 62 HSBC Finance Corporation-------------------------------------------------------------------------------- net interest income. Applying constant currency rates, which uses the averagerate of exchange for the 2004 period to translate current period net income, netincome would have been higher by $18 million in 2005. Loan impairment charges increased in 2005 primarily due to higher delinquencyand charge-off levels in the U.K. due to a general increase in consumer baddebts in the U.K. market, including increased bankruptcies. We increasedreserves in 2005 by recording loss provision greater than net charge-offs of$120 million. Operating expenses increased due to higher expenses to supportreceivable growth and collection activities and increased costs associated withbranch expansions in Canada. Net interest income increased in 2005 primarily due to higher average interestearning assets. Net interest margin decreased in 2005 due to increased cost offunds as well as overall lower yields on our customer loans. The lower overallyields were due to run-off of higher yielding customer loans and competitivepricing pressures holding down yields on our personal loans in the U.K.,partially offset by repricing initiatives and interest-free balances not beingpromoted as strongly in 2005 as in the past. Other operating income decreasedslightly as lower credit card fee income was offset by higher insurancerevenues. In December 2005, we sold our U.K. credit card business, including $2.5 billionof customer loans, and the associated cardholder relationships to HBEU for anaggregate purchase price of $3.0 billion. The purchase price, which wasdetermined based on a comparative analysis of sales of other credit cardportfolios, was paid in a combination of cash and $261 million of preferredstock issued by a subsidiary of HBEU with a rate of one-year Sterling LIBOR,plus 1.30 percent. In addition to the assets referred to above, the sale alsoincluded the account origination platform, including the marketing and creditemployees associated with this function, as well as the lease associated withthe credit card call center and the related leaseholds and call center employeesto provide customer continuity after the transfer as well as to allow HBEUdirect ownership and control of origination and customer service. We haveretained the collection operations related to the credit card operations andhave entered into a service level agreement for a period of not less than twoyears to provide collection services and other support services, includingcomponents of the compliance, financial reporting and human resource functions,for the sold credit card operations to HBEU for a fee. Additionally, themanagement teams of HBEU and our remaining U.K. operations will be jointlyinvolved in decision making involving card marketing to ensure that growthobjectives are met for both businesses. The International segment has recorded again on sale of $464 million as a result of this transaction. As the fair valueadjustments related to purchase accounting resulting from our acquisition byHSBC and the related amortization are allocated to Corporate, which is includedin the "All Other" caption within our segment disclosures, the gain recorded inthe International segment does not include the goodwill and intangible write-off resulting from this transaction of $288 million. Additionally, in a separate transaction in December 2005, we transferred ourinformation technology services employees in the U.K. to a subsidiary of HBEU.As a result, subsequent to the transfer operating expenses relating toinformation technology, which have previously been reported as salaries andfringe benefits or other servicing and administrative expenses, are now billedto us by HBEU and reported as support services from HSBC affiliates. Customer loans of $9.3 billion at December 31, 2005 decreased 29 percentcompared to $13.1 billion at December 31, 2004. The decrease was primarily dueto the sale of the U.K. credit card business to HBEU in December 2005, whichincluded customer loans of $2.5 billion. In addition to the sale of our creditcard operations in the U.K., our U.K. based unsecured receivable productsdecreased in 2005 due to lower retail sales volume following a slow down inretail consumer spending in the U.K. These decreases were partially offset bygrowth in the receivable portfolio in our Canadian operations. Branch expansionsin Canada in 2005 resulted in strong secured and unsecured receivable growth.Additionally, the Canadian auto finance program, which was introduced in thesecond quarter of 2004, grew to a network of over 1,000 active dealerrelationships at December 31, 2005. Also contributing to the receivable growthin Canada was the successful launch of a MasterCard credit card program.Applying constant currency rates, which uses the December 31, 2004 rate of 63 HSBC Finance Corporation-------------------------------------------------------------------------------- exchange to translate current customer loan balances, customer loans would havebeen higher by $648 million at December 31, 2005. ROA was 3.52 percent in 2005 and .98 percent in 2004. Excluding gain on sale ofthe U.K. credit card business in 2005, ROA was .12 percent in 2005 and .98percent in 2004. This decrease in 2005 reflects the lower net income asdiscussed above as well as higher average assets primarily due to receivablegrowth. RECONCILIATION OF SEGMENT RESULTS As previously discussed, segment results arereported on an IFRS Management Basis. See Note 21, "Business Segments," to theaccompanying financial statements for a discussion of the differences betweenIFRSs and U.S. GAAP. For segment reporting purposes, intersegment transactionshave not been eliminated. We generally account for transactions between segmentsas if they were with third parties. Also see Note 21, "Business Segments," inthe accompanying consolidated financial statements for a reconciliation of ourIFRS Management Basis segment results to U.S. GAAP consolidated totals. CREDIT QUALITY-------------------------------------------------------------------------------- DELINQUENCY AND CHARGE-OFF POLICIES AND PRACTICES Our delinquency and netcharge-off ratios reflect, among other factors, changes in the mix of loans inour portfolio, the quality of our receivables, the average age of our loans, thesuccess of our collection and customer account management efforts, bankruptcytrends, general economic conditions such as national and local trends in housingmarkets and interest rates and significant catastrophic events such as naturaldisasters and global pandemics. The levels of personal bankruptcies also have adirect effect on the asset quality of our overall portfolio and others in ourindustry. Our credit and portfolio management procedures focus on risk-based pricing andeffective collection and customer account management efforts for each loan. Webelieve our credit and portfolio management process gives us a reasonable basisfor predicting the credit quality of new accounts. This process is based on ourexperience with numerous marketing, credit and risk management tests. We alsobelieve that our frequent and early contact with delinquent customers, as wellas restructuring and other customer account management techniques which aredesigned to optimize account relationships, are helpful in maximizing customercollections. See Note 2, "Summary of Significant Accounting Policies," in theaccompanying consolidated financial statements for a description of ourcharge-off and nonaccrual policies by product. Our charge-off policies focus on maximizing the amount of cash collected from acustomer while not incurring excessive collection expenses on a customer whowill likely be ultimately uncollectible. We believe our policies are responsiveto the specific needs of the customer segment we serve. Our real estate and autofinance charge-off policies consider customer behavior in that initiation offoreclosure or repossession activities often prompts repayment of delinquentbalances. Our collection procedures and charge-off periods, however, aredesigned to avoid ultimate foreclosure or repossession whenever it is reasonablyeconomically possible. Our credit card charge-off policy is consistent withindustry practice. Charge-off periods for our personal non-credit card productand, prior to December 2004, our domestic private label credit card product weredesigned to be responsive to our customer needs and may therefore be longer thanbank competitors who serve a different market. Our policies have generally beenconsistently applied in all material respects. Our loss reserve estimatesconsider our charge-off policies to ensure appropriate reserves exist forproducts with longer charge-off lives. We believe our current charge-offpolicies are appropriate and result in proper loss recognition. DELINQUENCY Our policies and practices for the collection of consumer receivables, includingour customer account management policies and practices, permit us to reset thecontractual delinquency status of an account to current, based on indicia orcriteria which, in our judgment, evidence continued payment probability. When weuse a customer account management technique, we may treat the account as beingcontractually current 64 HSBC Finance Corporation-------------------------------------------------------------------------------- and will not reflect it as a delinquent account in our delinquency statistics.However, if the account subsequently experiences payment defaults and becomes atleast two months contractually delinquent, it will be reported in ourdelinquency ratios. At December 31, 2006 and 2005 our two-months-and-overcontractual delinquency included $2.5 billion and $2.3 billion respectively ofrestructured accounts that subsequently experienced payment defaults. See"Customer Account Management Policies and Practices" for further detail of ourpractices. The following table summarizes two-months-and-over contractual delinquency (as apercent of consumer receivables): 2006 2005 --------------------------------------- --------------------------------------- DEC. 31 SEPT. 30 JUNE 30 MARCH 31 DEC. 31 SEPT. 30 JUNE 30 MARCH 31---------------------------------------------------------------------------------------------------------- Real estate secured(1)........... 3.54% 2.98% 2.52% 2.46% 2.72% 2.51% 2.56% 2.62%Auto finance(2)........ 3.18 3.16 2.73 2.17 3.04 2.78 2.74 2.32Credit card(3)......... 4.57 4.53 4.16 4.35 3.66 4.46 4.14 4.60Private label.......... 5.31 5.61 5.42 5.50 5.43 5.22 4.91 4.71Personal non-credit card................. 10.17 9.69 8.93 8.86 9.40 9.18 8.84 8.63 ----- ---- ---- ---- ---- ---- ---- ----Total consumer(2),(3)...... 4.59% 4.19% 3.71% 3.66% 3.89% 3.84% 3.78% 3.83% ===== ==== ==== ==== ==== ==== ==== ==== --------------- (1) Real estate secured two-months-and-over contractual delinquency (as a percent of consumer receivables) are comprised of the following: 2006 2005 --------------------------------------- --------------------------------------- DEC. 31 SEPT. 30 JUNE 30 MARCH 31 DEC. 31 SEPT. 30 JUNE 30 MARCH 31 ------------------------------------------------------------------------------------------------------------------ Mortgage Services: First lien................... 4.50% 3.81% 3.10% 2.94% 3.21% 2.87% 2.84% 2.86% Second lien.................. 5.74 3.70 2.35 1.83 1.94 1.48 1.69 2.07 ---- ---- ---- ---- ---- ---- ---- ---- Total Mortgage Services........ 4.75 3.78 2.93 2.70 2.98 2.65 2.69 2.76 Consumer Lending: First lien................... 2.07 1.84 1.77 1.87 2.14 2.27 2.25 2.34 Second lien.................. 3.06 2.44 2.37 2.68 3.03 1.93 2.72 2.63 ---- ---- ---- ---- ---- ---- ---- ---- Total Consumer Lending......... 2.21 1.92 1.85 1.99 2.26 2.23 2.31 2.38 Foreign and all other: First lien................... 1.58 1.52 1.53 1.77 2.11 1.80 2.38 2.81 Second lien.................. 5.38 5.52 5.54 5.57 5.71 4.71 4.51 4.26 ---- ---- ---- ---- ---- ---- ---- ---- Total Foreign and all other.... 4.59 4.69 4.76 4.88 5.09 4.25 4.20 4.06 ---- ---- ---- ---- ---- ---- ---- ---- Total real estate secured...... 3.54% 2.98% 2.52% 2.46% 2.72% 2.51% 2.56% 2.62% ==== ==== ==== ==== ==== ==== ==== ==== (2) In December 2006, our Auto Finance business changed its charge-off policy to provide that the principal balance of auto loans in excess of the estimated net realizable value will be charged-off 30 days (previously 90 days) after the financed vehicle has been repossessed if it remains unsold, unless it becomes 150 days contractually delinquent, at which time such excess will be charged off. This resulted in a one-time acceleration of charge-off which totaled $24 million in December 2006. In connection with this policy change our Auto Finance business also changed its methodology for reporting two-months-and-over contractual delinquency to include loan balances associated with repossessed vehicles which have not yet been written down to net realizable value, consistent with policy. These changes resulted in an increase of 44 basis points to the auto finance delinquency ratio and an increase of 3 basis points to the total consumer delinquency ratio at December 31, 2006. Prior period amounts have been restated to conform to the current year presentation. (3) In December 2005, we completed the acquisition of Metris which included receivables of $5.3 billion. This event had a significant impact on this ratio. Excluding the receivables from the Metris acquisition from the December 2005 calculation, our consumer delinquency ratio for our credit card portfolio was 4.01% and total consumer delinquency was 3.95%. Compared to September 30, 2006, our total consumer delinquency increased 40basis points at December 31, 2006 to 4.59 percent. A significant factor in theincrease in the delinquency ratio was higher real estate secured delinquencylevels primarily at our Mortgage Services business as previously discussed, aswell as higher 65 HSBC Finance Corporation-------------------------------------------------------------------------------- personal non-credit card delinquency, partially offset by recent growth. Theincrease in the Consumer Lending real estate delinquency ratio was primarily dueto the addition of the Champion portfolio. While the Champion portfolio carrieshigher delinquency, its low loan-to-value ratios are expected to result in lowercharge-offs compared to the existing portfolio. Our auto finance delinquencyratio was broadly flat with September as decreases due to the change incharge-off policy were offset by seasonal increases in delinquency during thefourth quarter. The increase in the credit card delinquency ratio primarilyreflects seasoning, partially offset by the benefit of seasonal receivablegrowth. The decrease in private label delinquency (which primarily consists ofour foreign private label portfolio and domestic retail sales contracts thatwere not sold to HSBC Bank USA in December 2004) reflects recent receivablegrowth in our foreign portfolios. The increase in the personal non-credit carddelinquency ratio reflects maturation of a growing domestic portfolio as well asslight deterioration of certain customer groups in our domestic portfolio,partially offset by decreased delinquencies in our U.K. portfolio following theacceleration of charge-offs related to the cancellation of a forbearance programwhich provided that customers would not charge-off if certain minimum paymentconditions were met. We have implemented risk mitigation strategies in ourdomestic non-credit card portfolio, including tightening credit criteria andincreased collection capacity. Compared to December 31, 2005, our total consumer delinquency ratio increased 70basis points. This increase was driven by higher real estate secured delinquencylevels at our Mortgage Services business, higher credit card delinquency largelydue to the Metris portfolio acquired in December 2005, higher personal non-credit card delinquency driven by seasoning of a growing portfolio and higherdelinquency due to lower bankruptcy filings. These increases were partiallyoffset by receivable growth and the benefit of stable unemployment in the UnitedStates. See "Customer Account Management Policies and Practices" regarding the treatmentof restructured accounts and accounts subject to forbearance and other customeraccount management tools. See Note 2, "Summary of Significant AccountingPolicies," for a detail of our charge-off policy by product. 66 HSBC Finance Corporation-------------------------------------------------------------------------------- NET CHARGE-OFFS OF CONSUMER RECEIVABLES The following table summarizes net charge-off of consumer receivables as apercent of average consumer receivables: 2006 2005 --------------------------------------------- --------------------------------------------- QUARTER ENDED (ANNUALIZED) QUARTER ENDED (ANNUALIZED) 2004 FULL -------------------------------------- FULL -------------------------------------- FULL YEAR DEC. 31 SEPT. 30 JUNE 30 MAR. 31 YEAR DEC. 31 SEPT. 30 JUNE 30 MAR. 31 YEAR----------------------------------------------------------------------------------------------------------------------------------- Real estate secured(1).... 1.00% 1.28% .98% .97% .75% .76% .66% .75% .78% .87% 1.10%Auto finance(2)........... 3.67 4.97 3.69 2.43 3.50 3.27 3.42 3.25 2.61 3.80 3.43Credit card(3)............ 5.56 6.79 5.52 5.80 4.00 7.12 7.99 6.24 6.93 7.17 8.85Private label(3).......... 5.80 6.68 5.65 5.29 5.62 4.83 5.60 5.35 4.36 4.18 6.17Personal non-credit card(2)................. 7.89 7.92 7.77 7.92 7.94 7.88 7.59 8.01 7.77 8.18 9.75 ---- ---- ---- ---- ---- ---- ---- ---- ----- ----- ----Total consumer(2),(3)..... 2.97% 3.46% 2.92% 2.88% 2.58% 3.03% 3.10% 2.93% 2.93% 3.15% 4.00% ==== ==== ==== ==== ==== ==== ==== ==== ===== ===== ====Real estate charge-offs and REO expense as a percent of average real estate secured receivables............. 1.19% 1.68% 1.11% 1.04% .89% .87% .78% .88% .84% 1.01% 1.38% ==== ==== ==== ==== ==== ==== ==== ==== ===== ===== ==== --------------- (1) Real estate secured net charge-off of consumer receivables as a percent of average consumer receivables are comprised of the following: 2006 2005 --------------------------------------------- ---- QUARTER ENDED (ANNUALIZED) FULL -------------------------------------- FULL YEAR DEC. 31 SEPT. 30 JUNE 30 MAR. 31 YEAR ---------------------------------------------------------------------------------------------- Mortgage Services: First lien............................. .77% .91% .75% .73% .67% .68% Second lien............................ 2.38 4.40 2.11 1.72 1.15 1.11 ---- ---- ---- ---- ---- ---- Total Mortgage Services................. 1.12 1.66 1.06 .94 .77 .75 Consumer Lending: First lien............................. .85 .85 .84 .98 .71 .74 Second lien............................ 1.12 1.02 1.22 1.25 1.01 1.21 ---- ---- ---- ---- ---- ---- Total Consumer Lending.................. .89 .88 .90 1.02 .75 .80 Foreign and all other: First lien............................. .54 .89 .38 .99 .24 1.04 Second lien............................ .94 1.15 .91 .81 .63 .37 ---- ---- ---- ---- ---- ---- Total Foreign and all other............. .86 1.10 .81 .85 .56 .47 ---- ---- ---- ---- ---- ---- Total real estate secured............... 1.00% 1.28% .98% .97% .75% .76% ==== ==== ==== ==== ==== ==== 2005 -------------------------------------- QUARTER ENDED (ANNUALIZED) 2004 -------------------------------------- FULL DEC. 31 SEPT. 30 JUNE 30 MAR. 31 YEAR ---------------------------------------- ------------------------------------------------ Mortgage Services: First lien............................. .59% .71% .74% .72% .81% Second lien............................ .79 .93 1.31 1.79 2.64 ---- ---- ----- ----- ---- Total Mortgage Services................. .63 .74 .81 .85 1.05 Consumer Lending: First lien............................. .68 .74 .71 .82 1.03 Second lien............................ .84 1.06 1.22 1.76 2.77 ---- ---- ----- ----- ---- Total Consumer Lending.................. .70 .79 .78 .93 1.21 Foreign and all other: First lien............................. 1.10 .96 1.06 1.14 .89 Second lien............................ .49 .36 .41 .29 .24 ---- ---- ----- ----- ---- Total Foreign and all other............. .59 .45 .50 .41 .33 ---- ---- ----- ----- ---- Total real estate secured............... .66% .75% .78% .87% 1.10% ==== ==== ===== ===== ==== (2) In December 2006, our Auto Finance business changed its charge-off policy to provide that the principal balance of auto loans in excess of the estimated net realizable value will be charged-off 30 days (previously 90 days) after the financed vehicle has been repossessed if it remains unsold, unless it becomes 150 days contractually delinquent, at which time such excess will be charged off. This resulted in a one-time acceleration of charge-offs in December 2006, which totaled $24 million. Excluding the impact of this change the auto finance net charge-off ratio would have been 4.19 percent in the quarter ended December 31, 2006 and 3.46 percent for the full year 2006. Also in the fourth quarter of 2006, our U.K. business discontinued a forbearance program related to unsecured loans. Under the forbearance program, eligible delinquent accounts would not be subject to charge-off if certain minimum payment conditions were met. The cancellation of this program resulted in a one-time acceleration of charge-off which totaled $89 million. Excluding the impact of the change in the U.K. forbearance program, the personal non-credit card net charge-off ratio would have been 6.23 percent in the quarter ended December 31, 2006 and 7.45 percent for the full year 2006. Excluding the impact of both changes, the total consumer charge-off ratio would have been 3.17 percent for the quarter ended December 31, 2006 and 2.89 percent for the full year 2006. (3) The adoption of FFIEC charge-off policies for our domestic private label (excluding retail sales contracts at our Consumer Lending business) and credit card portfolios in December 2004 increased private label net charge-offs by 119 basis points, credit card net charge-offs by 2 basis points and total consumer net charge-offs by 16 basis points. Net charge-offs as a percentage of average consumer receivables decreased 6basis points for the full year of 2006 as compared to the full year of 2005.Decreases in personal bankruptcy net charge-offs in our credit card portfoliofollowing the October 2005 bankruptcy law changes in the United States wassubstantially offset by higher charge-offs in our real estate secured portfolioand in particular at our Mortgage Services business due to the deterioratingperformance of certain loans acquired in 2005 and 2006. We anticipate theincrease in net charge-off ratio for our real estate secured portfolio willcontinue in 2007 as a result of the higher delinquency 67 HSBC Finance Corporation-------------------------------------------------------------------------------- levels we are experiencing in loans purchased by Mortgage Services in 2005 and2006. The increase in the auto finance ratio for the full year 2006 reflectsseasoning of the portfolio and the one-time acceleration of charge-off totaling$24 million. The decrease in the credit card net charge-off ratio reflects thedecrease in personal bankruptcy filings discussed above, as well as the positiveimpact of receivable growth and higher recoveries in our credit card portfolioas a result of increased sales volumes of recent and older charged-off accounts.The net charge-off ratio for our private label receivables for the full year2006 and 2005 reflects decreased average receivables and the deterioration ofthe financial circumstances of some of our customers in the U.K. The personalnon-credit card charge-off ratio was broadly flat with the prior year asincreased charge-offs in both our domestic and U.K. businesses were offset byrecent growth in our domestic business. Charge-offs increased in our domesticbusiness due to seasoning of a growing portfolio. Charge-offs in our U.K.business increased due to declining receivables and the deterioration of thefinancial circumstances of some of our customers across the U.K. as well as theone-time acceleration of charge-offs totaling $89 million from the cancellationof a forbearance program in the U.K. as discussed above. We experienced an increase in overall net charge-off dollars across all productsin 2006. Higher losses at our Mortgage Services business as discussed above, aswell as portfolio growth and seasoning in our credit card and auto financeportfolios were major contributing factors to this increase. The increase in real estate charge-offs and REO expense as a percent of averagereal estate secured receivables in 2006 was primarily due to higher charge-offsin our real estate secured portfolio as discussed above, as well as higher REOexpense due to higher levels of owned properties and higher losses on sales dueto the slowing housing market, including an actual decline in some markets, inproperty values. Net charge-offs as a percentage of average consumer receivables decreased 97basis points for the full year of 2005 as compared to the full year of 2004. Thenet charge-off ratio for full year 2004 was impacted by the adoption of FFIECcharge-off policies for our domestic private label (excluding retail salescontracts at our Consumer Lending business) and credit card portfolios.Excluding the additional charge-offs in 2004 resulting from the adoption ofthese FFIEC policies, net charge-offs for the full year 2005 decreased 81 basispoints compared to 2004 as a result of receivable growth and the positive impactfrom the lower delinquency levels we have experienced as a result of a strongeconomy. This was partially offset by the increased charge-offs in the fourthquarter of 2005 for our credit card receivable portfolio resulting from thespike in bankruptcy filings prior to the effective date of new bankruptcylegislation in the United States. Our real estate secured portfolio experienceda decrease in net charge-offs for full year 2005 reflecting receivables growthand continuing strong economic conditions. The decrease in the auto financeratio for the full year 2005 reflects receivable growth with improved creditquality of originations, improved collections and better underwriting standards.The decrease in the credit card and personal non-credit card receivable netcharge-off ratios reflects the positive impact of changes in receivable mixresulting from lower securitization levels and continued improved creditquality. As discussed above, the decrease in the credit card ratio was partiallyoffset by increased net charge-offs resulting from higher bankruptcies. The netcharge-off ratio for the private label portfolio for the full year 2004 includesthe domestic private label portfolio sold to HSBC Bank USA which contributed 242basis points to the ratio. The net charge-off ratio for our private labelreceivables for the full year 2005 consists primarily of our foreign privatelabel portfolio which deteriorated in 2005 as a result of a general increase inconsumer bad debts in the U.K. markets, including increased bankruptcies. We experienced a decrease in overall net charge-off dollars in 2005. This wasprimarily due to lower delinquency levels we experienced as a result of thestrong economy, partially offset by higher receivable levels in 2005 as well ashigher net charge-offs in the fourth quarter of 2005 of an estimated $125million for our credit card receivable portfolio resulting from the increasedbankruptcy filings as discussed above. The decrease in real estate charge-offs and REO expense as a percent of averagereal estate secured receivables in 2005 from the 2004 ratio was primarily due tostrong receivable growth and the continuing strong economy. The 2005 ratio wasnot negatively impacted by the increased filings associated with the newbankruptcy legislation in the United States due to the timing of the bankruptcyfilings and our charge-off policy for real estate secured receivables. 68 HSBC Finance Corporation-------------------------------------------------------------------------------- NONPERFORMING ASSETS AT DECEMBER 31, 2006 2005 2004-------------------------------------------------------------------------------------- (IN MILLIONS) Nonaccrual receivables(1),(2)............................... $4,807 $3,608 $3,084Accruing consumer receivables 90 or more days delinquent.... 929 623 507Renegotiated commercial loans............................... 1 - 2 ------ ------ ------Total nonperforming receivables............................. 5,737 4,231 3,593Real estate owned........................................... 794 510 587 ------ ------ ------Total nonperforming assets.................................. $6,531 $4,741 $4,180 ====== ====== ====== --------------- (1) Nonaccrual receivables are comprised of the following: AT DECEMBER 31, 2006 2005 2004 -------------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured: Closed-end: First lien................................................ $1,893 $1,366 $1,295 Second lien............................................... 482 247 171 Revolving: First lien................................................ 22 31 40 Second lien............................................... 187 63 58 ------ ------ ------ Total real estate secured................................... 2,584 1,707 1,564 Auto finance................................................ 394 323 228 Credit card................................................. - - 51 Private label............................................... 76 75 78 Personal non-credit card.................................... 1,753 1,498 1,159 Commercial and other........................................ - 5 4 ------ ------ ------ Total nonaccrual receivables................................ $4,807 $3,608 $3,084 ====== ====== ====== (2) As previously discussed, in December 2006, our Auto Finance business changed its charge-off policy and in connection with this policy change also changed the methodology for reporting two-months-and-over contractual delinquency. These changes resulted in an increase in nonaccrual receivables at December 31, 2006. Prior period amounts have been restated to conform to the current year presentation. The increase in total nonperforming assets in 2006 is primarily due to higherlevels of real estate secured nonaccrual receivables at our Mortgage Servicesbusiness due to the deteriorating performance of certain loans acquired in 2005and 2006 as previously discussed. Real estate secured nonaccrual loans includedstated income loans at our Mortgage Services business of $571 million atDecember 31, 2006, $125 million at December 31, 2005 and $79 million at December31, 2004. The increase in total nonperforming assets in 2005 was primarily dueto the receivable growth we experienced in 2005 as well as the impact of theincreased bankruptcy filings on our secured and personal non-credit cardreceivable portfolios. Consistent with industry practice, accruing consumerreceivables 90 or more days delinquent includes domestic credit cardreceivables. CREDIT LOSS RESERVES We maintain credit loss reserves to cover probable lossesof principal, interest and fees, including late, overlimit and annual fees.Credit loss reserves are based on a range of estimates and are intended to beadequate but not excessive. We estimate probable losses for owned consumerreceivables using a roll rate migration analysis that estimates the likelihoodthat a loan will progress through the various stages of delinquency, or buckets,and ultimately charge-off. This analysis considers delinquency status, lossexperience and severity and takes into account whether loans are in bankruptcy,have been restructured or rewritten, or are subject to forbearance, an externaldebt management plan, hardship, modification, extension or deferment. Our creditloss reserves also take into consideration the loss severity expected based onthe underlying collateral, if any, for the loan in the event of default.Delinquency status may be affected by customer account management policies andpractices, such as the restructure of accounts, forbearance agreements, extendedpayment plans, modification arrangements, external debt management programs,loan 69 HSBC Finance Corporation-------------------------------------------------------------------------------- rewrites and deferments. If customer account management policies, or changesthereto, shift loans from a "higher" delinquency bucket to a "lower" delinquencybucket, this will be reflected in our roll rate statistics. To the extent thatrestructured accounts have a greater propensity to roll to higher delinquencybuckets, this will be captured in the roll rates. Since the loss reserve iscomputed based on the composite of all of these calculations, this increase inroll rate will be applied to receivables in all respective delinquency buckets,which will increase the overall reserve level. In addition, loss reserves onconsumer receivables are maintained to reflect our judgment of portfolio riskfactors that may not be fully reflected in the statistical roll ratecalculation. Risk factors considered in establishing loss reserves on consumerreceivables include recent growth, product mix, bankruptcy trends, geographicconcentrations, loan product features such as adjustable rate loans, economicconditions, such as national and local trends in housing markets and interestrates, portfolio seasoning, account management policies and practices, currentlevels of charge-offs and delinquencies, changes in laws and regulations andother items which can affect consumer payment patterns on outstandingreceivables, such as natural disasters and global pandemics. While our credit loss reserves are available to absorb losses in the entireportfolio, we specifically consider the credit quality and other risk factorsfor each of our products. We recognize the different inherent losscharacteristics in each of our products as well as customer account managementpolicies and practices and risk management/collection practices. Charge-offpolicies are also considered when establishing loss reserve requirements toensure the appropriate reserves exist for products with longer charge-offperiods. We also consider key ratios such as reserves to nonperforming loans andreserves as a percentage of net charge-offs in developing our loss reserveestimate. Loss reserve estimates are reviewed periodically and adjustments arereported in earnings when they become known. As these estimates are influencedby factors outside of our control, such as consumer payment patterns andeconomic conditions, there is uncertainty inherent in these estimates, making itreasonably possible that they could change. The following table sets forth credit loss reserves for the periods indicated: AT DECEMBER 31, ------------------------------------------ 2006 2005 2004 2003 2002---------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Credit loss reserves.............................. $6,587 $4,521 $3,625 $3,793 $3,333Reserves as a percent of receivables.............. 4.07% 3.23% 3.39% 4.11% 4.04%Reserves as a percent of net charge-offs.......... 145.8 123.8(2) 89.9(1) 105.7 106.5Reserves as a percent of nonperforming loans...... 114.8 106.9 100.9 92.8 93.7 --------------- (1) In December 2004, we adopted FFIEC charge-off policies for our domestic private label (excluding retail sales contracts at our Consumer Lending business) and credit card portfolios and subsequently sold this domestic private label receivable portfolio. These events had a significant impact on this ratio. Reserves as a percentage of net charge-offs excluding net charge-offs associated with the sold domestic private label portfolio and charge-off relating to the adoption of FFIEC was 109.2% at December 31, 2004. (2) The acquisition of Metris in December 2005 positively impacted this ratio. Reserves as a percentage of net charge-offs at December 31, 2005, excluding Metris was 118.2 percent. Credit loss reserve levels at December 31, 2006 increased as compared toDecember 31, 2005 as we recorded loss provision in excess of net charge-offs of$2,045 million. A significant portion of the increase in credit loss reservesresulted from higher delinquency and loss estimates at our Mortgage Servicesbusiness as previously discussed where we recorded provision in excess of netcharge-offs of $1,668 million. In addition, the higher credit loss reservelevels were a result of higher levels of receivables due in part to lowersecuritization levels and higher dollars of delinquency in our other businessesdriven by growth and portfolio seasoning including the Metris portfolio acquiredin December 2005. Reserve levels also increased due to weakening early stageperformance consistent with the industry trend in certain Consumer Lending realestate secured loans originated since late 2005. These increases were partiallyoffset by significantly lower personal bankruptcy levels in the United States, areduction in the estimated loss exposure relating to Katrina and the benefit ofstable unemployment in the United States. 70 HSBC Finance Corporation-------------------------------------------------------------------------------- Credit loss reserve levels of $2.1 billion at our Mortgage Services businessreflect our best estimate of losses in the portfolio at December 31, 2006. Inestablishing these reserve levels we considered the severity of losses expectedto be incurred, particularly in our second lien portfolio, above our historicalexperience given the current housing market trends in the United States. We alsoconsidered the ability of borrowers to repay their first lien adjustable ratemortgage loans at higher contractual reset rates given increases in interestrates by the Federal Reserve Bank from June 2004 through June 2006, as well astheir ability to repay any underlying second lien mortgage outstanding. Becausefirst lien adjustable rate mortgage loans are generally well secured, ultimatelosses associated with such loans are dependent to a large extent on the statusof the housing market and interest rate environment. Therefore, although it isprobable that incremental losses will occur as a result of rate resets on firstlien adjustable rate mortgage loans, such losses are estimable and, therefore,included in our credit loss reserves only in situations where the payment haseither already reset or will reset in the near term. A significant portion ofthe Mortgage Services second lien mortgages are subordinate to a first lienadjustable rate loan. For customers with second lien mortgage loans that aresubordinate to a first lien adjustable rate mortgage loan, the probability ofrepayment of the second lien mortgage loan is significantly reduced. The impactof future changes, if any, in the housing market will not have a significantimpact on the ultimate loss expected to be incurred since these loans, based onhistory and other factors, are expected to behave like unsecured loans. As aresult, expected losses for these loans are included in our credit loss reservelevels at December 31, 2006. Credit loss reserve levels at December 31, 2005 reflect the additional reserverequirements resulting from higher levels of owned receivables including lowersecuritization levels, higher delinquency levels in our portfolios driven bygrowth and portfolio seasoning, the impact of Katrina and minimum monthlypayment changes, additional reserves resulting from the Metris acquisition andthe higher levels of personal bankruptcy filings in both the United States andthe U.K. Credit loss reserves at December 31, 2005 also reflect the sale of ourU.K. credit card business in December 2005 which decreased credit loss reservesby $104 million. In 2005, we recorded loss provision greater than netcharge-offs of $890 million. In 2004, we recorded loss provision greater than net charge-offs of $301million. Excluding the impact of adopting FFIEC charge-off policies for domesticprivate label (excluding retail sales contracts at our Consumer Lendingbusiness) and credit card portfolios, we recorded loss provision $421 milliongreater than net charge-offs in 2004. Beginning in 2004 and continuing into 2005, we experienced a shift in our loanportfolio to lower yielding receivables, particularly real estate secured andauto finance receivables. Reserves as a percentage of receivables at December31, 2006 were higher than at December 31, 2005 due to the impact of additionalreserve requirements in our Mortgage Services business, partially offset bylower levels of personal bankruptcy filing in the United States and a reductionin the estimated loss exposure estimates relating to Katrina. Reserves as apercentage of receivables at December 31, 2005 and 2004 were lower than atDecember 31, 2003 as a result of portfolio growth, partially offset in 2005 bythe impact of additional credit loss reserves relating to the impact of Katrina,minimum monthly payment changes and increased bankruptcy filings. Reserves as apercentage of receivables at December 31, 2003 were higher than at December 31,2002 as a result of the sale of $2.8 billion of higher quality real estatesecured loans to HSBC Bank USA in December 2003. Had this sale not occurred,reserves as a percentage of receivables at December 2003 would have been lowerthan 2002 as a result of improving credit quality in the latter half of 2003 asdelinquency rates stabilized and charge-off levels began to improve. The trendsin the reserve ratios for 2003 and 2002 reflect the impact of the weak economy,higher delinquency levels, and uncertainty as to the ultimate impact theweakened economy would have on delinquency and charge-off levels. Reserves as a percentage of nonperforming loans increased in 2006. This increasewas primarily attributable to higher reserve levels primarily as a result ofhigher loss estimates in our Mortgage Services business as previously discussed.Reserves as a percentage of nonperforming loans increased in 2005. Whilenonperforming loans increased in 2005, reserve levels in 2005 increased at amore rapid pace due to receivable growth, the 71 HSBC Finance Corporation-------------------------------------------------------------------------------- additional reserve requirements related to Katrina and impact of increasedbankruptcy filings on our secured receivable and personal non-credit cardreceivable portfolios which did not migrate to charge-off until 2006. Reserves as a percentage of net charge-offs increased compared to 2005 asreserve levels grew more rapidly than charge-offs primarily due to the highercharge-offs expected in 2007 related to the deterioration in certain mortgageloans acquired in 2005 and 2006. Reserves as a percentage of net charge-offsincreased in 2005. The 2005 ratio was significantly impacted by the acquisitionof Metris and the 2004 ratio was significantly impacted by both the sale of ourdomestic private label receivable portfolio (excluding retail sales contracts)in December 2004 as well as the adoption of FFEIC charge-off policies for ourdomestic private label (excluding retail sales contracts) and credit cardportfolios. Excluding these items, reserves as a percentage of net charge-offsincreased 900 basis points. While both our reserve levels at December 31, 2005and net charge-offs in 2005 were higher than 2004, our reserve levels grew forthe reasons discussed above more rapidly than our net charge-offs. See the "Analysis of Credit Loss Reserves Activity," "Reconciliations to U.S.GAAP Financial Measures" and Note 7, "Credit Loss Reserves," to the accompanyingconsolidated financial statements for additional information regarding our lossreserves. CUSTOMER ACCOUNT MANAGEMENT POLICIES AND PRACTICES Our policies and practicesfor the collection of consumer receivables, including our customer accountmanagement policies and practices, permit us to reset the contractualdelinquency status of an account to current, based on indicia or criteria which,in our judgment, evidence continued payment probability. Such policies andpractices vary by product and are designed to manage customer relationships,maximize collection opportunities and avoid foreclosure or repossession ifreasonably possible. If the account subsequently experiences payment defaults,it will again become contractually delinquent. In the third quarter of 2003, we implemented certain changes to ourrestructuring policies. These changes were intended to eliminate and/orstreamline exception provisions to our existing policies and were generallyeffective for receivables originated or acquired after January 1, 2003.Receivables originated or acquired prior to January 1, 2003 generally are notsubject to the revised restructure and customer account management policies.However, for ease of administration, in the third quarter of 2003, our MortgageServices business elected to adopt uniform policies for all products regardlessof the date an account was originated or acquired. Implementation of the uniformpolicy by Mortgage Services had the effect of only counting restructuresoccurring on or after January 1, 2003 in assessing restructure eligibility forpurposes of the limitation that no account may be restructured more than fourtimes in a rolling sixty-month period. Other business units may also elect toadopt uniform policies. The changes adopted in the third quarter of 2003 havenot had a significant impact on our business model or on our results ofoperations as these changes have generally been phased in as new receivableswere originated or acquired. As discussed in more detail below, we also revisedcertain policies for our domestic private label credit card and credit cardportfolios in December 2004. As discussed previously and described more fully in the table below, we adoptedFFIEC account management policies regarding restructuring of past due accountsfor our domestic private label credit card and credit card portfolios inDecember 2004. These changes have not had a significant impact on our businessmodel or on our results of operations. Approximately three-fourths of all restructured receivables are securedproducts, which in general have less loss severity exposure because of theunderlying collateral. Credit loss reserves take into account whether loans havebeen restructured, rewritten or are subject to forbearance, an external debtmanagement plan, modification, extension or deferment. Our credit loss reservesalso take into consideration the loss severity expected based on the underlyingcollateral, if any, for the loan. Our restructuring policies and practices vary by product and are described inthe table that follows and reflect the revisions from the adoption of FFIECcharge-off and account management policies for our domestic private label(excluding retail sales contracts at our Consumer Lending business) and creditcard receivables in December 2004. The fact that the restructuring criteria maybe met for a particular account does not 72 HSBC Finance Corporation-------------------------------------------------------------------------------- require us to restructure that account, and the extent to which we restructureaccounts that are eligible under the criteria will vary depending upon our viewof prevailing economic conditions and other factors which may change from periodto period. In addition, for some products, accounts may be restructured withoutreceipt of a payment in certain special circumstances (e.g. upon reaffirmationof a debt owed to us in connection with a Chapter 7 bankruptcy proceeding). Weuse account restructuring as an account and customer management tool in aneffort to increase the value of our account relationships, and accordingly, theapplication of this tool is subject to complexities, variations and changes fromtime to time. These policies and practices are continually under review andassessment to assure that they meet the goals outlined above, and accordingly,we modify or permit exceptions to these general policies and practices from timeto time. In addition, exceptions to these policies and practices may be made inspecific situations in response to legal or regulatory agreements or orders. In the policies summarized below, "hardship restructures" and "workoutrestructures" refer to situations in which the payment and/or interest rate maybe modified on a temporary or permanent basis. In each case, the contractualdelinquency status is reset to current. "External debt management plans" refersto situations in which consumers receive assistance in negotiating or schedulingdebt repayment through public or private agencies. RESTRUCTURING POLICIES AND PRACTICES HISTORICAL RESTRUCTURING POLICIES FOLLOWING CHANGES IMPLEMENTED AND PRACTICES(1),(2),(3) IN THE THIRD QUARTER 2003 AND IN DECEMBER 2004(1),(2),(3)---------------------------------------------------------------------------------------------------------- REAL ESTATE SECURED REAL ESTATE SECURED Real Estate - Overall Real Estate - Overall(4) - An account may be restructured if we - Accounts may be restructured prior to the end of the receive two qualifying payments within the monthly cycle following the receipt of two qualifying 60 days preceding the restructure; we may payments within 60 days restructure accounts in hardship, disaster - Accounts generally are not eligible for restructure or strike situations with one qualifying until nine months after origination payment or no payments - Accounts will be limited to four collection - Accounts that have filed for Chapter 7 restructures in a rolling sixty-month period bankruptcy protection may be restructured - Accounts whose borrowers have filed for Chapter 7 upon receipt of a signed reaffirmation bankruptcy protection may be restructured upon agreement receipt of a signed reaffirmation agreement - Accounts subject to a Chapter 13 plan - Accounts whose borrowers are subject to a Chapter 13 filed with a bankruptcy court generally plan filed with a bankruptcy court generally may be require one qualifying payment to be restructured upon receipt of one qualifying payment restructured - Except for bankruptcy reaffirmation and filed Chapter 13 plans, agreed automatic payment withdrawal or hardship/disaster/strike, accounts are generally limited to one restructure every twelve-months - Accounts generally are not eligible for - Except for bankruptcy reaffirmation and filed Chapter restructure until they are on the books 13 plans, accounts will generally not be restructured for at least six months more than once in a twelve-month period - Accounts whose borrowers agree to pay by automatic withdrawal are generally restructured upon receipt of one qualifying payment after initial authorization for automatic withdrawal(5) 73 HSBC Finance Corporation-------------------------------------------------------------------------------- RESTRUCTURING POLICIES AND PRACTICES HISTORICAL RESTRUCTURING POLICIES FOLLOWING CHANGES IMPLEMENTED AND PRACTICES(1),(2),(3) IN THE THIRD QUARTER 2003 AND IN DECEMBER 2004(1),(2),(3)---------------------------------------------------------------------------------------------------------- Real Estate - Consumer Lending Real Estate - Mortgage Services(6),(7) - Accounts whose borrowers agree to pay by - Accounts will generally not be eligible for automatic withdrawal are generally restructure until nine months after origination restructured upon receipt of one qualifying payment after initial authorization for automatic withdrawalAUTO FINANCE AUTO FINANCE - Accounts may be extended if we receive one - Accounts may generally be extended upon receipt of qualifying payment within the 60 days two qualifying payments within the 60 days preceding preceding the extension the extension - Accounts may be extended no more than - Accounts may be extended by no more than three months three months at a time and by no more than at a time three months in any twelve-month period - Accounts will be limited to four extensions in a - Extensions are limited to six months over rolling sixty-month period, but in no case will an the contractual life account be extended more than a total of six months - Accounts that have filed for Chapter 7 over the life of the account bankruptcy protection may be restructured - Accounts will be limited to one extension every six upon receipt of a signed reaffirmation months agreement - Accounts will not be eligible for extension until - Accounts whose borrowers are subject to a they are on the books for at least six months Chapter 13 plan may be restructured upon - Accounts whose borrowers have filed for Chapter 7 filing of the plan with a bankruptcy court bankruptcy protection may be restructured upon receipt of a signed reaffirmation agreement - Accounts whose borrowers are subject to a Chapter 13 plan may be restructured upon filing of the plan with the bankruptcy courtCREDIT CARD CREDIT CARD - Typically, accounts qualify for Accounts originated between January 2003 - December restructuring if we receive two or three 2004 qualifying payments prior to the - Accounts typically qualified for restructuring if we restructure, but accounts in approved received two or three qualifying payments prior to external debt management programs may the restructure, but accounts in approved external generally be restructured upon receipt of debt management programs could generally be one qualifying payment restructured upon receipt of one qualifying payment - Generally, accounts may be restructured - Generally, accounts could have been restructured once once every six months every six months Beginning in December 2004, all accounts regardless of origination date - Domestic accounts qualify for restructuring if we receive three consecutive minimum monthly payments or a lump sum equivalent - Domestic accounts qualify for restructuring if the account has been in existence for a minimum of nine months and the account has not been 74 HSBC Finance Corporation-------------------------------------------------------------------------------- RESTRUCTURING POLICIES AND PRACTICES HISTORICAL RESTRUCTURING POLICIES FOLLOWING CHANGES IMPLEMENTED AND PRACTICES(1),(2),(3) IN THE THIRD QUARTER 2003 AND IN DECEMBER 2004(1),(2),(3)---------------------------------------------------------------------------------------------------------- restructured in the prior twelve months and not more than once in the prior five years - Domestic accounts entering third party debt counseling programs are limited to one restructure in a five-year period in addition to the general limits of one restructure in a twelve-month period and two restructures in a five-year periodPRIVATE LABEL(8) PRIVATE LABEL(8) Private Label - Overall Private Label - Overall - An account may generally be restructured Prior to December 2004 for accounts originated after if we receive one or more qualifying October 2002 payments, depending upon the merchant - For certain merchants, receipt of two or three - Restructuring is limited to once every six qualifying payments was required, except accounts in months (or longer, depending upon the an approved external debt management program could be merchant) for revolving accounts and once restructured upon receipt of one qualifying payment every twelve-months for closed-end accounts Private Label - Consumer Lending Retail Private Label - Consumer Lending Retail Sales Contracts Sales Contracts - Accounts may be restructured if we/receive - Accounts may be restructured upon receipt of two one qualifying payment within the 60 days qualifying payments within the 60 days preceding the preceding the restructure; may restructure restructure accounts in a hardship/disaster/strike - Accounts will be limited to one restructure every six situation with one qualifying payment or months no payments - Accounts will be limited to four collection - If an account is never more than 90 days restructures in a rolling sixty-month period delinquent, it may generally be - Accounts will not be eligible for restructure until restructured up to three times per year six months after origination - If an account is ever more than 90 days delinquent, generally it may be restructured with one qualifying payment no more than four times over its life; however, generally the account may thereafter be restructured if two qualifying payments are received - Accounts subject to programs for hardship or strike may require only the receipt of reduced payments in order to be restructured; disaster may be restructured with no payments 75 HSBC Finance Corporation-------------------------------------------------------------------------------- RESTRUCTURING POLICIES AND PRACTICES HISTORICAL RESTRUCTURING POLICIES FOLLOWING CHANGES IMPLEMENTED AND PRACTICES(1),(2),(3) IN THE THIRD QUARTER 2003 AND IN DECEMBER 2004(1),(2),(3)---------------------------------------------------------------------------------------------------------- PERSONAL NON-CREDIT CARD PERSONAL NON-CREDIT CARD - Accounts may be restructured if we receive - Accounts may be restructured upon receipt of two one qualifying payment within the 60 days qualifying payments within the 60 days preceding the preceding the restructure; may restructure restructure accounts in a hardship/disaster/strike - Accounts will be limited to one restructure every six situation with one qualifying payment or months no payments - Accounts will be limited to four collection - If an account is never more than 90 days restructures in a rolling sixty-month period delinquent, it may generally be - Accounts will not be eligible for restructure until restructured up to three times per year six months after origination - If an account is ever more than 90 days delinquent, generally it may be restructured with one qualifying payment no more than four times over its life; however, generally the account may thereafter be restructured if two qualifying payments are received - Accounts subject to programs for hardship or strike may require only the receipt of reduced payments in order to be restructured; disaster may be restructured with no payments --------------- (1) We employ account restructuring and other customer account management policies and practices as flexible customer account management tools as criteria may vary by product line. In addition to variances in criteria by product, criteria may also vary within a product line. Also, we continually review our product lines and assess restructuring criteria and they are subject to modification or exceptions from time to time. Accordingly, the description of our account restructuring policies or practices provided in this table should be taken only as general guidance to the restructuring approach taken within each product line, and not as assurance that accounts not meeting these criteria will never be restructured, that every account meeting these criteria will in fact be restructured or that these criteria will not change or that exceptions will not be made in individual cases. In addition, in an effort to determine optimal customer account management strategies, management may run more conservative tests on some or all accounts in a product line for fixed periods of time in order to evaluate the impact of alternative policies and practices. (2) For our United Kingdom business, all portfolios have a consistent account restructure policy. An account may be restructured if we receive two or more qualifying payments within two calendar months, limited to one restructure every 12 months, with a lifetime limit of three times. In hardship situations an account may be restructured if a customer makes three consecutive qualifying monthly payments within the last three calendar months. Only one hardship restructure is permitted in the life of a loan. There were no changes to the restructure policies of our United Kingdom business in 2006, 2005 or 2004. (3) Historically, policy changes are not applied to the entire portfolio on the date of implementation but are applied to new, or recently originated or acquired accounts. However, the policies adopted in the third quarter of 2003 for the Mortgage Services business and the fourth quarter of 2004 for the domestic private label (excluding retail sales contracts) and credit card portfolios were applied more broadly. The policy changes for the Mortgage Services business which occurred in the third quarter of 2003, unless otherwise noted, were generally applied to accounts originated or acquired after January 1, 2003 and the historical restructuring policies and practices are effective for all accounts originated or acquired prior to January 1, 2003. Implementation of this uniform policy had the effect of only counting restructures occurring on or after January 1, 2003 in assessing restructure eligibility for the purpose of the limitation that no account may be restructured more than four times in a rolling 60 month period. These policy changes adopted in the third quarter of 2003 did not have a significant impact on our business model or results of operations as the changes are, in effect, phased in as receivables were originated or acquired. For the adoption of FFIEC policies which occurred in the fourth quarter of 2004, the policies were effective immediately for all receivables in the domestic private label credit card and the credit card portfolios. Other business units may also elect to adopt uniform policies in future periods. (4) In some cases, as part of the Consumer Lending Foreclosure Avoidance Program, accounts may be restructured on receipt of one qualifying payment. In the fourth quarter of 2006, this treatment was extended to accounts that qualified for the Mortgage Services account modification plan, as long as it has been at least six months since such account was originated, even if the account had been restructured in the last twelve months. Such restructures may be in addition to the four collection restructures in a rolling sixty-month period. Accounts receive these restructures after proper verification of the customer's ability to make continued payments. This generally includes the determination and verification of the customer's financial situation. At December 31, 2006 and 2005 Consumer Lending had $674 million and $497 million, respectively, of accounts restructured on receipt of one qualifying payment under the Foreclosure Avoidance Program. At December 31, 2006 Mortgage Services had $134 million of accounts restructured on receipt of one qualifying payment under the account modification plan. 76 HSBC Finance Corporation-------------------------------------------------------------------------------- (5) Our Mortgage Services business implemented this policy for all accounts effective March 1, 2004. (6) Prior to January 1, 2003, accounts that had made at least six qualifying payments during the life of the loan and that agreed to pay by automatic withdrawal were generally restructured with one qualifying payment. (7) Prior to August 2006, Mortgage Services accounts could not be restructured until nine months after origination and six months after the loan was acquired. (8) For our Canadian business, private label accounts are limited to one restructure every four months and if originated or acquired after January 1, 2003, two qualifying payments must be received, the account must be on the books for at least six months, at least six months must have elapsed since the last restructure, and there may be no more than four restructures in a rolling 60 month period. The tables below summarize approximate restructuring statistics in our managedbasis domestic portfolio. Managed basis assumes that securitized receivableshave not been sold and remain on our balance sheet. We report our restructuringstatistics on a managed basis only because the receivables that we securitizeare subject to underwriting standards comparable to our owned portfolio, aregenerally serviced and collected without regard to ownership and result in asimilar credit loss exposure for us. As the level of our securitized receivableshave fallen over time, managed basis and owned basis results have now largelyconverged. As previously reported, in prior periods we used certain assumptionsand estimates to compile our restructure statistics. The systemic counters usedto compile the information presented below exclude from the reported statisticsloans that have been reported as contractually delinquent but have been reset toa current status because we have determined that the loans should not have beenconsidered delinquent (e.g., payment application processing errors). Whencomparing restructuring statistics from different periods, the fact that ourrestructure policies and practices will change over time, that exceptions aremade to those policies and practices, and that our data capture methodologieshave been enhanced, should be taken into account. TOTAL RESTRUCTURED BY RESTRUCTURE PERIOD - DOMESTIC PORTFOLIO(1)(MANAGED BASIS) AT DECEMBER 31, 2006 2005--------------------------------------------------------------------------- Never restructured.......................................... 89.1% 89.5%Restructured: Restructured in the last 6 months......................... 4.8 4.0 Restructured in the last 7-12 months...................... 2.4 2.4 Previously restructured beyond 12 months.................. 3.7 4.1 ----- ----- Total ever restructured(2)................................ 10.9 10.5 ----- -----Total....................................................... 100.0% 100.0% ===== ===== RESTRUCTURED BY PRODUCT - DOMESTIC PORTFOLIO(1)(MANAGED BASIS) AT DECEMBER 31, 2006 2005--------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS Real estate secured......................................... $10,344 11.0% $ 8,334 10.4%Auto finance................................................ 1,881 15.1 1,688 14.5Credit card................................................. 816 2.9 774 3.0Private label(2)............................................ 31 10.9 26 7.3Personal non-credit card.................................... 3,600 19.5 3,369 19.9 ------- ---- ------- ----Total(3).................................................... $16,672 10.9% $14,191 10.5% ======= ==== ======= ==== --------------- (1) Excludes foreign businesses, commercial and other. (2) Only reflects Consumer Lending retail sales contracts which have historically been classified as private label. All other domestic private label receivables were sold to HSBC Bank USA in December 2004. (3) Total including foreign businesses was 10.6 percent at December 31, 2006 and 10.3 percent at December 31, 2005. 77 HSBC Finance Corporation-------------------------------------------------------------------------------- MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock Exchange
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